How to seek performance while investing with your conscience.
You may not have to give up competitive returns when you choose investments based on your social values.
From the Chief Investment Office at Merrill Lynch.
Impact investing means different things to different people, but generally it refers to investments made in companies, organizations and funds with the intention to generate measurable social and environmental impact alongside a financial return. Impact investing, originally referred to as socially responsible investing, was previously limited to screening stocks or industries to eliminate companies whose practices did not align with the investor's values. It has significantly evolved as an investment and risk management approach, and it now may enable investors to reflect environmental, social and governance (ESG) considerations in their investment portfolios without having to sacrifice potential returns. Strategies span asset classes and issues such as climate change and access to finance, health care and education, letting investors simultaneously pursue both financial and nonfinancial goals.
Institutional investors were among the first to incorporate impact investing criteria into their mandates, and they still account for the largest share of assets. However, recent substantial growth in sources of ESG data as well as a rising number of private companies that have dual objectives of financial and social returns now make it possible for all investors to incorporate impact investing into their portfolios. For example, in 2011, only 20% of the S&P 500 companies issued reports on their corporate social responsibility. By 2014, that number had jumped to 75%.1 The number of investment funds incorporating ESG factors has nearly doubled in that time period (from less than 500 funds in 2010 to more than 900 in 2014), and assets have risen roughly 650% (from $569 billion in 2010 to $4.3 trillion in 2014).2
In 2011, only 20% of the S&P 500 companies issued reports on their corporate social responsibility. By 2014, that number had jumped to 75%.
A different climate for impact investing
While many investors are interested in reflecting environmental or social issues in their investment portfolios, they have traditionally held back because of a commonly held belief that it would require a trade-off in performance. It is true that the historical standard of negative screens can amplify risk by reducing diversification and potentially cause unintended concentration of specific firms or sectors, resulting in a portfolio's underperformance. However, we believe that a combination of more reliable data, enhanced portfolio construction techniques, and innovation in structures and investment approaches is starting to reverse that outdated mentality. These structural changes support a growing body of evidence showing that investors can do well financially by investing in organizations that are doing what's right for the environment and society.
Many impact investments can be used in a market-based portfolio without sacrificing potential returns and without significant increases in risk. In fact, studies have shown that companies demonstrating ESG principles have been able to reduce risk and potentially enhance shareholder value. For example, a 2014 study by the climate change organization CDP found that S&P 500 industry leaders on climate change generated 18% higher return on equity (ROE), 50% lower volatility of earnings over the past decade, and 21% stronger dividend growth than their peers that had low scores for responding to climate issues.3 Another study by the firm Analytic Investors showed that companies with a higher ESG rating tended to have a more stable pattern of returns, potentially helping to better preserve capital in a portfolio.
An array of choices can meet needs and preferences
The risk and return characteristics of impact investments can vary, and understanding them is critical for investment decision-making.
For example, investors in an alternative energy strategy are using capital to create a positive impact on the environment. So in addition to having the potential for lowering carbon emissions, investors are expecting a higher return because alternative energy companies are working in a high-growth-oriented space. Conversely, investment strategies that focus on microfinance and community development offer a significant potential for social impact, but often yield lower returns than traditional strategies with credit risk that is not rated by a reputed agency. This is due to the fact that there needs to be a cap on the financial return for investors to avoid diluting the benefit to low-income communities
A U.S. Trust survey found that 60% of millennials and 34% of Gen Xers are interested in or currently use social impact investments.4
Impact investing is poised to grow in significance in the coming years. According to the 2015 U.S. Trust Insights on Wealth and Worth survey, younger generations see no reason to separate investing and impact, which is why 60% of millennials and 34% of Generation X are interested in or currently use social impact investments. Increasingly better data and improved portfolio construction techniques that make it even easier to integrate impact into an investment process, without sacrificing returns, will only help speed this along.
Adapted from "Impact Investing: The Performance Realities," a white paper by Anna Snider, Global Head of Equity and Impact Investing Due Diligence, Merrill Lynch Global Wealth and Retirement Services (November 2015).