The investment landscape is rapidly evolving. At the forefront of change lies Impact investing, albeit this concept is not novel.
The Evolution of Responsible Investing
Socially responsible investing, otherwise known as SRI, emerged in the 1970s when investors began including or avoiding specific stocks or industries in their investment portfolios through positive or negative screening mechanisms. The most widely used socially responsible investing approach was negative screening, manifesting in the form of investment portfolios that excluded investments in guns, tobacco, gambling, adult entertainment and other vices.
The rationale behind such an approach was that allocating capital towards these “sin stocks” was bolstering “bad” industries and therefore capital should only be allocated towards “good” industries. Most of these responsible investments were pursued for moral reasons, with little consideration of the economics.
The critique of this conventional form of socially responsible investing, therefore, was that these “sinful” companies might have been capable of providing positive characteristics in another way, as well as adding to investment return, and therefore exclusion of such companies was potentially limiting diversification and other capital growth opportunities in the investment portfolio.
Modern Portfolio Theory further contends that the chief impediment to achieving an optimal return on investment through the conventional form of SRI is that narrowing the investment universe in such a manner will not result in an optimal portfolio. Modern Portfolio Theory and, specifically, the Capital Asset Pricing Model, though riddled with simplified assumptions, asserts that – ceteris paribus – the optimal risk-return profile can only be achieved when the entire investable universe is considered. Therefore, excluding part of the investment universe could be deemed short-sighted.
The advent of environmental, social and governance investing, otherwise known as ESG investing, diminished the use of SRI as an investment strategy, although investors continued to use the terms synonymously.
SRI and ESG investing, however – although both forms of “investing responsibly” – are far from synonymous. In contrast to positive or negative screening, ESG investing is the integration of environmental, social and governance factors into the fundamental investment process. ESG investing is an outgrowth of previous iterations of SRI.
It is the consideration and inclusion of environmental, social and governance factors, among others, when selecting companies in which to invest. And why shouldn’t investors consider such factors? Presumably, the longevity of any company is tied to its commitment to environmental friendliness which often leads to reduced costs and increased efficiencies, social considerations such as fair treatment of employees and strict governance standards, such as a fairly represented Board of Directors or clearly delineated roles of shareholders and stakeholders.
Interestingly, governance is commonly the most overlooked of the three E, S and G factors. Yet, a strong corporate governance system of principles, policies and procedures is necessary in order to resolve potential conflicts and risks inherent in a corporation. A robust corporate governance system is, therefore, essential to reducing operational risk and increase sustainability within organizations.
The rationale for ESG investing is the following: companies which adhere to high quality environmental, social and governance standards are likely to outperform in the long-run. As defined on the Gitterman company website: “ESG factors offer portfolios managers added insight into the quality of a company’s management, culture, risk profile and other characteristics.” Understanding environmental, social and governance facets of a company are viewed as pertinent to understanding said company’s ability to outperform its peers.
Despite a long endured misconceived trade-off between investing in “do-good” companies and achieving optimal investment returns, ESG investing proves that it is, in fact, possible to achieve both simultaneously.
A successful ESG money manager typically engages in the following strategy: First, he/she will identify a set of compelling investments, based on his/her traditional investment selection criteria. Subsequent to doing so, then, he/she will apply an ESG lens to this set of viable investments. Last, but not least, he/she selects those investments that are anticipated to generate a scalable, profitable impact. The reason why impact and returns need not be mutually exclusive is because the ESG lens is only applied to profitable investments that have been identified pre-lens.
Although “ESG investing” and “Impact investing” are often erroneously used as synonyms, the two are, in fact, not one in the same.
Impact investing is the most advanced of all past iterations of investing to accelerate environmental and/or social change. Impact investing is the investment into a company, fund or organization with the intention of generating a measurable environmental and/or social impact alongside financial return. Alongside – not instead of.
A comprehensive collection of plan sponsors, fund managers and consultants have turned their attention to understanding and implementing ESG investing, driven by both moral and economic intentions. Impact investing proves that business is not zero-sum: that it is possible to “do good” and “make money” at the same time. Of course, it is conceivable for profit and impact to be at odds with each other. However, if implemented correctly, financial profitability and engendering a positive environmental and/or social impact need not be mutually exclusive.
Gitterman Wealth Management has exemplified this through its SMART portfolios: an Impact investing customized solution to fulfill each of its client’s needs. SMART astutely stands for Sustainability Metrics Applied to Risk Tolerance. Gitterman’s SMART portfolios have all been meticulously researched through a process that began with the analysis of every single mutual fund in the Morningstar universe – a total of 22,000 funds. In March of 2016, the Morningstar Universe implemented a global ESG rating scale, which has allowed Gitterman to conduct such detailed due diligence.
Subsequent to identifying high-ranking ESG funds, Gitterman Wealth Management applies a customized risk and return analysis to the highest performers, arriving at unique solutions for each of its clients. In this way, Gitterman Wealth Management is investing with the intention of creating positive environmental and/or social impact.
Consideration vs. Intention
The Merriam Webster definition of consideration is, “a careful thought: the act of thinking carefully about something you will make a decision about.” In contrast, the Merriam Webster definition of intent is, “the thing that you plan to do or achieve: an aim or purpose.”
Herein lies the exact difference between ESG and Impact investing. While ESG investing is the consideration of environmental, social and governance aspects of companies, alongside the various other characteristics money managers use to compare companies, Impact investing describes the intentional investment in a company, pursued specifically to fashion positive impact on the environment and/or society.