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ESG and impact investing: Do you know the difference?

Impact investing helps advisers to differentiate their practice by providing compelling mandates such as support for resilient infrastructure

Feb 20, 2018 @ 2:45 pm

By Mike Faloon and Alex Laipple

As investors increasingly rally behind the concept that their investment choices yield the ability to positively impact social or environmental issues, interest in impact investing has skyrocketed. Of the more than 22,000 investors worldwide surveyed by Schroders for its Global Investor Study 2017, 78% claimed they place more emphasis on sustainability than they did five years prior. And 64% indicated that they have increased their allocations to sustainable funds over the last five years — and nowhere was this shift more pronounced that in the U.S.

A wealth of data further corroborates a shift in how we as a nation view our investment decisions. According to SIFMA, the market size of sustainable, responsible and impact investing in the United States was $8.72 trillion as of 2016 — double what it was just four years previously. And it's clear that this isn't a passing fad: In the almost two decades from 1995 to 2016, assets held in responsibly managed asset pools grew from $639 billion. That's an increase of 1,265%!

In short, the impact investment revolution is upon us.

Leading this charge is the millennial generation, whose penchant for social causes that serve the greater good has been widely documented. According to Morgan Stanley's Institute for Sustainable Investing, this cohort is twice as likely as the overall population to invest in sustainable assets – and early predictions indicate that the ensuing Gen Zers will share their affinity for impact. With the next generation of investors set to inherit $59 trillion in assets between now and 2060, this is a critical time for advisers to consider how best to position their impact offering. By crafting a message that resonates with their audience and explaining clearly how impact investing can be incorporated as part of a well-managed portfolio, financial services professionals can deepen client relationships and capture new assets.

Advisers are understandably keen to meet clients' growing interest in this space. The problem? While they might have a high-level understanding of core concepts, many unwittingly fall short by utilizing key terminology interchangeably. To communicate effectively with clients and gain their trust – which will ultimately attract more assets – it's important to understand the differences.

Let's start by taking a closer look at two terms we hear frequently — ESG and impact investing — and how they differ.

(More: ESG investing: Assessing the 'E,' 'S' and 'G')

Environmental, Social and Governance

An ESG framework can be integrated in the risk-return analysis of investment opportunities. Drawing from a wealth of data, gathered from company disclosures, government databases and other sources, it empowers investment professionals and their clients to examine how companies are managing risks and opportunities in three key areas:

Environmental: How is the company disposing of hazardous waste? Is it managing carbon emissions? To what extent is it meeting environmental regulations?

Social: Does the company support philanthropic and community-focused initiatives? Are employees provided with access to health care and other key benefits? Is leadership promoting diversity?

Governance: Are company leaders appropriately qualified for the role, and are they communicating a coherent strategic vision? Are their compensation packages appropriately aligned with performance? Is the C-suite communicating effectively, and transparently, with shareholders?

One thing that's key: As an adviser utilizing ESG criteria when making investment decisions on behalf of your client, you are still empowered to purchase a security (unless it has been explicitly restricted by said client) — regardless of its effect on the environment or society. For example, you might assess the probability that big oil companies' carbon assets become stranded during their holding period. The probability is incorporated into the investment's cash flow projections and discount rate. If the risk-return output is acceptable to you as the adviser, and falls within client guidelines, you can make the investment on behalf of the client.

An ESG framework is a valuable tool that can be used to evaluate how certain behaviors positively affect a company's performance, and subsequently drive investing decisions. It is not, however, a strategy in and of itself.

(More: Is ESG investing going mainstream?)

Impact Investing

Neighborly's work in communities across the country has demonstrated a strong appetite among individual investors for innovative, sustainable opportunities that directly address social and environmental issues. The enthusiasm we've witnessed in locations such as Cambridge, Mass., and Burlington, Vt., points to one thing: a growing desire among investors to do well by doing good. That's where impact investing comes in.

Impact investing focuses on utilizing capital to effect positive social or environmental change, while simultaneously generating strong returns. The two needn't be mutually exclusive. In fact, data increasingly suggest that funds with impact missions generate comparable ROI when assessed against those that are focused solely on optimal returns.

As an adviser, impact investing enables you to differentiate your practice by providing compelling mandates such as support of expanded access to clean energy, the creation of resilient infrastructure or enhanced social and economic mobility for underprivileged communities. Consider presenting an investment mandate to your clients that allows them to fight climate change or another issue that they place in high regard – it's a pretty powerful message.

However, while providing an impact investing strategy is a powerful marketing tool, it's important that you take time to educate yourself — and subsequently your clients — on the associated risks. There is the possibility that certain opportunities may underperform relative to other widely available options; investors may also be exposed to liquidity risk and experience difficulty exiting the investment under certain circumstances. Financials aside, there is a chance that the intended social impact goals may not be achieve. It's imperative that you have an honest conversation with them to evaluate goals and appropriately manage expectations.

As impact investing moves toward the mainstream and increasingly represents a core offering rather than a "nice to have," it's imperative that advisers who wish to remain competitive take the time to understand its core elements. The impact revolution is already underway, and you don't want to be left behind.

(More: Advisers ignore 'responsible investing' at their own risk)

Mike Faloon is chief strategy officer for Neighborly, a technology company that provides direct access to impact investing through municipal bonds. Alex Laipple is director of business development and impact investing at Neighborly.

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