Distribution: The difference between what and how

Lynn Strongin Dodds examines the factors that distinguish impact investing from ESG.

The world of responsible investing can be confusing, with several terms used interchangeably. Today the most common is environmental, social and governance (ESG). 

But over the past three years, impact investing has been added to the vernacular – and because the two are often sold under the same fund moniker, investors are advised to look carefully at the fine print to see what they are buying.

At a high level, impact investing is focusing on companies that generate measurable, verifiable, beneficial social or environmental outcomes alongside financial returns. “In practice, the business must be addressing an unmet need which cannot be easily addressed by other means, thereby creating a direct impact,” says Quyen Tran, sustainable investment strategist at Wellington Management.

“Examples include innovative companies that provide affordable housing, financial services or education and job training to underserved populations. Financial objectives for impact investing strategies vary and range from concessionary to market-beating returns,” adds Tran.

ESG, on the other hand, can be used as a risk management tool and tends to analyse how these factors affect the performance of the company. They are increasingly being integrated alongside traditional financial metrics to help identify potential threats and opportunities beyond technical valuations. “ESG analysis evaluates how a company conducts its business – the ‘how’ of a company, whereas impact investing evaluates a company’s products and services, or the ‘what’ of a company,” says Tran.

A mighty morphing minnow?
Investors should take note that a company with a favourable ESG score does not automatically qualify as an impact company and vice versa for an impact company, according to Tran. “We think best practice is for impact investing strategies to integrate ESG analysis and engagement into the investment process,” he adds. “Doing so allows a manager to evaluate a company holistically, from its business operations to its products and services.”

Impact investing can trace its origins to philanthropy, with the term being coined by the Rockefeller Foundation in 2008. However, it has gained traction in conventional fund management circles due to the United Nations’ 17 sustainable development goals (SDGs), published two years ago. Also labelled ‘Global Goals’, they help provide a framework for key performance indicators.

To date, figures from the Global Impact Investing Network’s (GIIN) Sizing the Impact Investing Market study show there are 1,350 asset managers with around $502 billion (€458 billion) of assets under management globally in impact investing. However, albeit expanding, it is a relative minnow against the broader US market where there is $12 trillion alone targeted for sustainable investing practices, according to the Forum for Sustainable and Responsible Investment 2018 report.

Linking capital to outcomes
Their growing popularity, though, has meant that ESG funds are becoming firm fixtures on fund platforms and this is set to only rise. They are either sold as thematic or specialist funds or as mainstream funds that integrate ESG criteria. A recent study by fund management group Natixis found that that two-thirds of the 200 fund managers, insurers and wealth managers polled expect consideration of ESG factors to be “standard practice” for fund buyers within five years; and 49% said it is already a consideration.

This is not the case with impact investing vehicles because they are relatively new and have been mainly the preserve of the private sphere. Public equities, for example, account for a small proportion – roughly 14% – of the $502 billion market highlighted in the GIIN survey and there is a debate as to whether companies on the stock market can deliver the goods.

As Jonathan Dean, head of impact investing at Axa Investment Managers, points out, traditionally, impact investing started by using private (alternative) assets – private equity, private debt, project finance – but it is increasingly seen as a strategy that can be pursued across the investment spectrum, from private markets to listed assets.

“Our view is that while investing for impact via listed securities can offer relative benefits of scale and liquidity, private market programmes deliver the strongest ‘intentionality’ around linking capital to impact outcomes,” he says.

James Purcell, head of sustainable and impact investing at UBS Global Wealth Management, adds: “For example, if you buy shares of a solar company on the secondary market, the behaviour of the company has not changed, and you are not having an impact. However, if you provide fresh capital through private markets and the company doubles its solar capacity, your capital has contributed to reducing carbon emissions, which is measurable and verifiable.”

There is, though, a rising band of investors as well as asset owners who want to use their collective voice to influence the impact and ESG agenda.

An engagement story
“Stewardship is now widely viewed as an important part of investment, with investors wanting to actively engage companies to align the companies’ activities with their interests,” says Leon Kamhi, head of responsibility at Hermes Investment Management. The firm has two impact strategies: the Hermes Impact Opportunities Fund, which invests in companies that produce tangible societal and environmental outcomes; and the SDG Engagement Equity Fund, which uses engagement to improve performance.

These are high-conviction strategies with targeted outcomes, according to Kamhi. For example, the Impact Opportunity Fund only has 30 stocks out of the MSCI All World Country Index’s 8,500 universe.

To be included in the SDG Engagement Equity Fund, an investment needs to have an engagement story. “Notwithstanding these constraints, I think impact investing in public markets will increase,” he adds. “Delivering a positive impact has come to the fore and there is a growing recognition that it is not sustainable to invest in companies that do not treat their workers and supply chain well or pay attention to health and safety or gender pay gaps.”

Fixed income
In the fixed income world, green bonds, which raise debt finance for specific environmentally oriented projects, is one of the fastest-growing segments. They are sold as separate products, but research from the Climate Bonds Initiative, a London-based non-profit which promotes investment in the low-carbon economy, shows that issuance is climbing, surpassing the $100 billion mark in the first half of the year. While they account for a fraction of the overall bond market, they are piquing interest due to the need to raise trillions of dollars to meet the Paris Agreement’s emissions-cut targets.

Simon Bond, director of responsible investment portfolio management at Columbia Threadneedle, also believes the International Capital Market Association’s (ICMA) standards were important catalysts for both green and social bonds. ICMA’s Green Bond, as well as the Social Bond Principles and Sustainable Bond Guidelines Principles, which were updated last June, are voluntary guidelines for good practice around transparency and disclosure.

“Green, social and sustainability bonds have a much more targeted approach,” says Bond. “The principles provide a framework to help analyse the general corporate purpose of the bonds and the use of proceeds. The biggest challenge is that it is difficult to measure social outcomes of, say, healthcare and education on society. With the environment, it is easier to get consistent data when, for example, looking at the reduction in carbon emissions.”

Steve Waygood, chief responsible investment officer at Aviva Investors, concurs, adding that the industry is still determining the right practices, data and criteria needed to measure impact from a governance and performance perspective.

Last year, the fund manager, along with the Index Initiative and the United Nations Foundation, launched the World Benchmarking Alliance (WBA): publicly available benchmarks that rank companies on their contributions to achieving the SDGs.

However, “there is no ubiquitous or universal measures, but I believe that in five to ten years there will be”, Waygood adds. “It took 150 years for financial accounting standards to be developed – and it will also take time in this case.”

Impact investing is still seen as a niche segment, but the momentum is gathering for a spectrum of sustainable investment products – and it will become an important feature of the wider offering.

©2019 funds europe

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