How to Invest With Impact
We have so many problems to tackle as a society right now: climate change, political corruption, income and gender inequality, deforestation and now add in a global pandemic. Making progress in all of these areas is of existential importance for humanity: socially, environmentally and financially. It’s in all of our best interest to care, because the actions we take - and don’t take - today shape our future. If you’re reading this post, it’s likely that you are fortunate enough to have an extremely powerful tool you can use to help solve some of the world’s biggest problems and drive real, positive change: your investments.
The way it works is pretty simple. When we invest in stocks and corporate bonds, we lend money to corporations so they can complete projects, grow profits and provide us a return on our investment. If we choose to invest only in companies that benefit society and the planet, we’re essentially voting on them with our dollars, incentivizing them to grow their businesses. Steering capital away from companies that do harm sends a wake-up call that they either need to get their act together or start doing something else.
That’s an incredible amount of power - and it’s called impact investing.
Photo by Azis Pradana
What is impact investing?
Impact investing goes by many names, often used interchangeably. But there are three main types that, in practice, each mean something different:
ESG (Environmental and Social Governance) stands for a company’s environmental, social and governance practices (e.g., energy usage policies, treatment of employees and compliance with regulators). Investors use rating systems to assess the quality of companies’ ESG policies and decide whether or not to invest.
SRI (Socially Responsible Investing) involves actively choosing (or avoiding) investments based on specific, sometimes very strict, ethical guidelines.
Impact investing directly invests in businesses or organizations that are completing projects, developing programs or taking actions that positively benefit society.
All three of these investing strategies often overlap when building an impact investment portfolio, and no matter which approach is being used, the goal is the same: to maximize investment returns while making a positive impact on society.
What makes an investment “good”?
The first thing that comes to mind when thinking about impact investing is usually the SRI approach of avoiding “sin stocks” - publicly traded companies that are involved in an activity that’s considered to be immoral or unethical. These are things like tobacco, weapons, gambling, sex industries and alcohol. Fossil fuels are popular among sin stocks too. But the idea of what’s ethical is open to interpretation. Some people consider big agriculture and big pharma to be problematic industries. Political beliefs can also influence an investor’s perspective - for example, a military contractor like Halliburton could be an ethical deal breaker for some and a patriotic investment for others.
On the ESG side, lots of companies may have great scores but still get their hands dirty, especially if they’re multibillion dollar businesses with operations all over the world. Costco, for instance, treats its employees notoriously well, scoring high on the “social” aspect of ESG. It tends to do well in other ESG areas too, but still, the sale of its consumer brands requires a massive amount of palm oil and timber to be sourced from deforestation-risk producers and traders - an unfortunate plight for the orangutans.
Photo by Dawn Armfield
Another challenge with ESG is that there’s no standardized rating system. Instead there are many third-party data providers, all using different methodologies. MSCI ESG Research, one of the largest independent providers of ESG ratings, rates over 7,500 global companies and more than 650,000 equity and fixed income securities - they look at 37 key ESG issues and 10 themes in their analysis, including things like climate change, pollution & waste, human capital, social opportunities and corporate behavior. Corporate Knights, another data provider, bases their rankings on an analysis of 14 key performance indicators and publishes an annual report of what they’ve determined to be the 100 top sustainable companies in the world.
Ultimately, what makes a company “good” is up to the investor’s judgment, and luckily there are non-profit organizations, like As You Sow and Green America, that are dedicated to providing investors with robust resources to navigate the many socially responsible investment products that exist.
How does impact investing work in practice?
An impact investment portfolio, whether it’s made up of a 401(k), a Roth IRA or a regular, taxable investment account, is built mostly with a combination of mutual funds and/or ETFs (exchange-traded funds), both of which are pooled investments, allowing investors to afford diversification benefits by purchasing a fractional share of a huge portfolio - comprising anywhere between 100 and 3,000 different individual securities.
The key difference between mutual funds and ETFs is that shares of mutual funds are usually bought through an investment company and are actively managed, while shares of ETFs are freely traded on market exchanges and have low fees because they’re built to passively mimic the behavior of a broader index (e.g. the S&P 500, an index of 500 large U.S. companies). ETFs are especially useful in building an impact portfolio because they’re low cost and highly liquid, meaning they can easily be bought and sold.
To give an example, a socially responsible mutual fund like Green Century’s Balanced Fund (GCBLX) completely avoids fossil fuel companies, GMOs, nuclear energy, nuclear weapons and tobacco. It’s actively managed by Green Century, requires a minimum investment of up to $2,500 depending on the account type, and charges a fee (also called expense ratio) of 1.48%, which means that a $100,000 investment would be charged $1,480 a year. On the other hand, the iShares MSCI KLD 400 Social ETF (DSI) is a bundle of 400 stocks that meets ESG criteria for positive environmental, social and governance characteristics. It can be traded at any time on an exchange with no minimum investment, and has an expense ratio of 0.25%, which means that a $100,000 investment would be charged $250 a year.
ETFs are Mana’s investment vehicle of choice for exactly these reasons: diversification, high liquidity, flexibility and low fees.
Increased demand brings more availability.
Impact investing is the furthest thing from a new fad. It’s been around since biblical times, but it really started picking up speed and evolving into its modern form in the 1960’s and 1970’s when Vietnam War protestors started demanding that university endowment funds divest from defense contractors. So many different types of ESG funds have been created since then, and they’re still on the rise. In the U.S., ESG fund growth is up more than 200% from the previous decade. In 2014 there were about 130 sustainable funds available to investors, and now there are over 250, with more than 200 other funds formally considering ESG criteria in their investment management process. By the beginning of 2018, $11.6 trillion of professionally managed assets in the United States were using SRI strategies - that’s about $1 in every $4 invested.
This high level of growth means that fees on diversified ESG ETFs have come way down: of the 47 diversified ESG ETFs that cover equities and fixed-income securities, 15 of them charge between 0.09% and 0.2% in fees and only six charge more than 0.4%. We see the growing availability of low-cost, highly liquid ESG investments as an exciting opportunity to start integrating socially responsible investing strategies into our portfolio offerings. The growing variety of funds will allow us to more easily provide clients with impact driven asset class exposure without sacrificing on performance, low fees, and our global positioning.
Impact investing and financial return.
Impact investing wouldn’t be as popular as it is right now if returns weren’t competitive. Socially responsible portfolios have at least been keeping pace with their non-SRI counterparts. The MSCI KLD 400 Social Index (an index of 400 U.S. companies with high ESG ratings) held its own with a 7.53% average annual return over a 15-year period while the S&P 500 (an index of 500 large U.S. companies) had a 7.77% return for the same period. In January, Bloomberg reported that nine of the biggest ESG mutual funds in the U.S. outperformed the S&P 500. And over the past 10 years, Vanguard’s FTSE Social Index (a fund that tracks an index of ESG-screened companies called FTSE4Good US Select) had a return of 12.19%, outperforming the S&P 500’s return of 11.59%.
As we noted in our annual investment letter, research shows that doing good through impact investing doesn’t mean sacrificing returns. McKinsey points out that ESG links to cash flow in five important ways: (1) facilitating top-line growth, (2) reducing costs, (3) minimizing regulatory and legal interventions, (4) increasing employee productivity, and (5) optimizing investment and capital expenditures. An exhaustive study in the Journal of Sustainable Finance & Investment combed through the findings of about 2,200 prior empirical studies dating all the way back to the 1970s on the relation between ESG criteria and corporate financial performance, and found that ESG had a consistently positive impact on corporate financial performance over time. It’s becoming clear that regardless of whether or not the motive to invest is for impact, companies with good ESG policies should be attractive to investors either way.
In the recent pandemic-induced falling market, ESG funds have proven themselves by showing greater resiliency than non-ESG portfolios.
Morningstar uses a sustainability ratings system that ranks funds from one to five globes, based on risk scores of the underlying companies that make up the funds. They found that when the S&P 500 index fell by 23.6% in the first quarter, large company stock funds with five-globe ratings had an average decline of 17.7% - while the same type of funds with a Morningstar rating of one globe lost 26.6%. This indicates that companies with strong ESG policies are likely to be better equipped to handle shocks to the business, mitigating risk for losses to portfolio value.
Mana’s Focus: Fossil fuels and gender equity.
Two areas we want to explore first when starting to build impact portfolios are fossil fuel free and gender equity investments. Climate change and gender equity are two of the most important global issues of our time. As a women-led business and a group of people who care about leaving a better world for future generations, we take these issues seriously. They also hold very real weight in portfolio value, especially when it comes to downside risk.
Fossil fuels as an industry has particular vulnerabilities. Global shocks like this current pandemic, natural disasters, war, political strife, government regulations and accidents like oil spills can all cause values to plummet and potentially extreme volatility (how intensely share prices swing up and down). As the need to shift away from carbon emissions and stave off climate change becomes even more dire, fossil fuels become even more at risk from waning public sentiment and potential landmark regulatory changes.
Gender diversity and equity - or a lack thereof - poses its risks in a portfolio as well. Studies show that a lack of diversity in management can hinder returns. Credit Suisse published a report in 2016 showing that companies with a higher proportion of women in leadership roles generate higher returns and can better manage downside risks. Credit Suisse also showed through an analysis of 2,400 companies that large companies with at least one woman on the board outperformed companies in the same category with no women on the board by a 26% return on equity, a big difference. And a study in 2009 found compelling evidence that having female directors reduces the likelihood of companies becoming insolvent (i.e. bankrupt).
Investing away from fossil fuels and towards gender equity both have impactful value-add implications for the economy. Advancing clean and renewable energy lifts societal burdens by reducing pollution and its associated healthcare costs, making communities more resilient to natural disasters and mitigating the potentially catastrophic effects of global climate change. Likewise, investing in companies that are taking real actions to promote gender diversity in all areas of work, including leadership, and especially on a global scale, helps to close a gap that, according to McKinsey research, could potentially grow the economy by $12 to $28 trillion dollars by 2025 if reduced or eliminated. To be clear, this is not a zero-sum game. When women are able to fully participate in the economy, the influx of invaluable talent and leadership expands the overall pool of wealth and enriches all of our lives.
Conclusion
I believe that money should be spent and invested purposefully, in ways that align with our goals and values. Impact investing is an exciting opportunity to do just that while creating more wealth for ourselves and society. It allows us to be agents of change and tackle some of the toughest issues we’ve ever faced. It’s a beautiful blend of responsibility and privilege to know that aligning our wealth with values of social and environmental stewardship can make us all better off - because doing the right thing with our investments, it turns out, tends to reduce risk and drive up portfolio value. Looking ahead I see socially responsible investing becoming more of the norm, as people realize that ESG qualities like corporate transparency and community engagement are things that simply make a company more sustainable and profitable. The growing availability of socially responsible funds will allow us to better serve clients who want to invest for impact with creative portfolio models that still maximize returns and align with their goals. If impact investing is something you’re interested in, talk to us! We’d love to hear your thoughts.
Brandon Tacconelli is an Investment Specialist at Mana Financial Life Design. Mana Financial Life Design provides comprehensive financial life planning and investment management services to help clients organize, grow and protect their wealth throughout life’s journey.