Sustainable and profitable: what research reveals about impact investing
Is impact investing profitable?
If you ever thought about investing sustainably, you probably asked yourself this very question.
And you’re not alone.
A 2017 survey from Morgan Stanley reveals that more and more investors (75%) want to invest sustainably — yet at the same time they also believe (53%) that, by doing so, they’ll have to trade-off the financial returns in the honour of “impact”. However, to add some confusion to the mix, 71% of investors, in the same survey, agree that sustainable investing can lead to higher profitability.
So which one is it? Is impact investing profitable? Or does it always come at a price?
Let’s dive in.
1. To this date, empirical research shows no evidence that impact affects returns.
2. In fact, according to studies and investor surveys, impact investing performs in-line and above investors’ expectations.
3. Impact investing prevents investment assets from becoming “stranded” and is increasingly used as a risk management strategy.
First things first: what is impact investing?
The term “impact investing” was coined back in 2007 — yet, of course, the belief of doing well by doing good has been in practice for a while. But here’s some food for thought: when we say “impact investing”, do we know what “impact” really is?
"Impact" is a word that has different meanings for different people. What it means to you, might differ from what it means to someone else.
This is because terms like “impact” or “sustainability” aren’t actually protected or standardized in the finance industry (or any other industry, for that matter). There are no uniform standards for sustainable investment labels, meaning that every investment product can decide if they’re “green enough” pretty much on their own accord, with a selective level of transparency. (This can hurt, and hurt badly, by the way: Just in February 2021, DekaBank, for example, was sued for not being transparent with their clients on what they mean by “impact” for their impact equity fund.)
So on the face of it, impact may seem subjective and the kind of impact an investor would like to make is unique to the values of this specific investor. Still, the official definition by GIIN (Global Impact Investing Network) sees impact investing as “investments made into companies, organizations, and funds with the intention to generate measurable social and environmental impact alongside a financial return.”
(The keyword in this definition is “measurable”. Which means that you should be able to quantify impact and track it clearly and transparently. But that’s a different story.)
But definitions aside, the mainstream concern remains: Is impact investing profitable? Is there a real basis for the fear that impact comes at a sacrifice for financial returns?
To answer this question, we first need to address where this fear comes from.
Every portfolio manager knows the principles of Modern Portfolio Theory (MPT): a mathematical framework for assembling a portfolio based on risk & return. This basic premise was developed in the 1950s and assumes that for higher risk (or volatility) investors should demand greater returns.
When applying the MPT to portfolio building, it’s generally accepted that there exists a set of optimal portfolios for any group of assets, in order to be able to deliver the highest level of returns for a given level of risk. When these optimal portfolios are “plotted” beside each other on a financial risk and returns graph, they form what is known as “the efficient frontier”. Portfolios that lie below the efficient frontier are sub-optimal since they simply don’t provide enough return for the level of risk. Portfolios that are clustered to the right of the efficient frontier are also considered sub-optimal because they have a higher risk for the defined rate of return.
There’s one other important thing you need to know about the efficient frontier: it’s two-dimensional. It doesn’t contain any information about any social, environmental, or other impact characteristic. So, in this given framework, what would happen if we added an “impact dimension”?
The critics of impact investing argue that any movement from a portfolio that’s optimized for risk & return is, by default, sub-optimal. This is where the assumption that investing and ethics don’t go well together stems from: because impact simply doesn’t fit into this traditional framework.
Modern Portfolio Theory also suggests that portfolios constructed from an investment universe of, say, 2,000 companies will be more efficient than portfolios constructed from a smaller investment universe of, say, 1,500 companies (as they will have higher expected returns and/or lower expected volatility due to bigger diversification). Or, in other words: since impact investing would work with a smaller investment universe, it would therefore generate lower expected risk-adjusted returns.
And yet, to this date, there’s been no evidence to suggest that any of these theories are true when it comes to impact investing.
In fact, research and studies suggest exactly the opposite: that investing with impact proves to be a profitable, fruitful venture.
For example, the Royal Bank of Canada looked at more than 50 major studies and identified that socially responsible investing (SRI) does NOT result in lower investment returns. Integrating sustainability factors into the investment process eliminates companies that are actually expected to perform poorly since the excluded companies are engaged in unsustainable activities or practices that will make them less profitable over time.
Harvard University also found the same exact thing: that applying socially responsible criteria has NO negative impact on the risk-return ratio. This is backed by research from Bank of America, which identified that high sustainability companies deliver 47% higher returns than their low-sustainability counterparts, while exhibiting lower volatility.
Which, to put it simply, means that your investments, if sustainable, are very likely to stay future-proof because those companies are more likely to stay future-proof.
Companies that embrace corporate social responsibility will deliver better financial performance than competitors that do not, and market participants systematically overlook these positive factors.
— ROYAL BANK OF CANADA, GLOBAL ASSET MANAGEMENT
This same sentiment is echoed by GIIN which, in 2019, surveyed professional investors that are collectively managing nearly $239 billion in impact assets. GIIN found that the overwhelming majority of respondents (90%) reported that their investments were either in-line or above their expectations for both impact (98%) and financial performance (91%).
Researchers from the Wharton Social Impact Initiative (WSII) also conducted a rigorous survey of 53 impact investing private equity funds from around the world to see if there really is a trade-off between maximizing financial returns and impact. Their findings, too, found that there’s no evidence to suggest that. In fact, the data showed that mission-aligned investments can provide strong returns, at or near the overall market.
There’s more: Cary Krosinsky and Nick Robins, in their book Sustainable Investing: The Art of Long Term Performance, found that an investment selection strategy that actively identifies sustainable companies leads to financial outperformance, compared to simply screening the unsuitable companies out (the so-called “negative screening” that eliminates companies e.g. from specific sectors) or using passive investment instruments like the MSCI World or S&P 500 indices:
SOURCE: BANK OF AMERICA, BASED ON KROSINSKY & ROBINS
This research can go on and on.
So long story short? Get over your fears — 91% of them don’t become true anyways (according to research 🤓).
Potential enhanced profitability is not the only reason to consider impact investing. Another benefit is the layer of risk management that impact investing brings to the table.
Impact-driven investing has significantly evolved as a risk management approach, as it helps to avoid the so-called “stranded assets”: assets that have suffered from devaluations and/or have become a liability.
Carbon Tracker Initiative introduced the concept of stranded assets to get people thinking about the implications of not adjusting their investments to be in line with the emissions trajectories required to limit global warming. The term refers to investments that used to be valuable before but became worthless over time because their “value” is threatened by changing legislative regulations, environmental factors, or investment preferences.
As the world is looking to restrict global warming to well below 2°C, there are already examples of assets that are becoming stranded due to their inability to undergo a successful carbon transition. For example, the oil & gas industry falls under the stranded asset category (no big surprise). In any of the three stranding scenarios — economic, physical, or regulatory — when the value of the asset is lost, the stock price plunges.
Of course, the fossil stocks are still surviving, but then again, they’re doing just that: surviving. There are still $ millions invested in these fossil fuel companies which are doing their job of elevating the stock prices, but, despite that, these assets are more likely to become worthless in the future anyway. (Think about it. It’s 2021: do you even know anyone who genuinely wants to invest in, say, fossils at this point?)
When using the impact investing approach, you would be looking at assets that are less carbon-intensive, are majorly capable of transitioning, and are able to deliver positive forward-looking sustainability metrics. Impact investing, in other words, helps you outvote and filter out the potential losers that don’t have the capability to survive the climate crisis — and helps you prevent your assets from becoming stranded.
The younger generation doesn’t see financial and impact returns being separate: they want to see both. While there is tons of research suggesting that impact investing is profitable, there’s, to this date, no real historical benchmark to rely on — simply because impact investing is still relatively new to the game. The standardisation of the impact metrics is still to come. The impact reporting regulations are still to come. The benchmarks are still to come.
And yet, the capital market is already changing. Things have evolved since the 1950s when investments were based purely on risk & return metrics, so while measurable, standardized, transparent impact metrics are still in the workings, they are already on the way. The key is not to wait “for the perfect metric” to arrive tomorrow and start investing for impact then. The key is to invest now, where change needs to happen today — from investing in climate technologies to investing in laggard industries that are on the transition to net-zero because we will (and still are) in need for those industries in the years to come.
So, is impact investing profitable? It surely could be. But you’ll never find out — if you won’t start impact investing yourself.