Investing for Maximum Impact

Impact Investing has rapidly evolved. When it first came into vogue nearly 30 years ago, the idea was largely met with skepticism. Investments that hinged on values were considered philanthropic gestures practiced by a handful of investors trying to make a statement. Many values-based investors used strategies that depended on avoidance: Effect change by screening out companies and products they saw as negative, such as alcohol or tobacco. But that technique limited investments and created portfolio gaps.

Over the last decade, impact investing has reached the next level, partly due to investors’ views of our interconnected economy, combined with greater sophistication in tracking and analysis of markets. Investors are helping to drive the era of “conscious consumers,” who are shopping at organic stores, buying goods from companies with clear social missions and driving cars that are environmentally friendly.

“With these strategies, we see a real combination of social impact and financial returns,” says Chris Hyzy, chief investment officer for Bank of America Global Wealth & Investment Management. “It’s not just one or the other. There’s no doubt that impact investing allows investors’ capital to contribute to positive social return.”

Meanwhile, today’s investors are mindful that business and society don’t operate in separate spheres. This situation is prompting investors to seek out companies they believe will have a competitive advantage over their peers by using sustainable business strategies. That doesn’t mean putting social or environmental issues before returns; rather, it means considering the needs of a company’s various stakeholders—including employees and the surrounding community—and striking a balance that works for everyone.

Today’s investors are looking for opportunities to build a more nuanced, lasting form of wealth that strengthens both their portfolios and the world around them—socially, ethically and environmentally.

HOW HAS THE SPECTRUM OF INVESTING EVOLVED?

There is a growing awareness that capital can be used to address social issues just as effectively as grants or other philanthropic efforts (if not more so). That awareness has helped clarify the relationship between impact and traditional investing.

“You can think of impact investing as a spectrum,” says Anna Snider, head of Due Diligence & Impact Investing, Merrill Lynch Wealth Management. “There used to be the world of traditional investing on one end, and philanthropy on the other. Now we’re understanding that there’s a whole series of ways of looking at having impact, but not solely through philanthropic means.”

For some investors, this might mean investing in strategies that look for companies with environmental, social and governmental, or ESG, best practices. For others, religious principles might drive investments. Still others may seek out strategies that address specific social issues such as health care or workplace diversity. Investing along a spectrum lets investors customize their impact by focusing on a core group of issues and maximizing their impact there.

“Investors are recognizing that impact investing is not only a question of values, but also a tool to identify structural investment opportunities such as energy alternatives, financing gaps both in the U.S. and the developing world, or new education and healthcare- based technologies,” says Snider.

The spectrum of impact investing ranges from investors who are willing to sacrifice some or all return in order to advance a cause, to those who seek fully competitive returns. What’s most important, though, is that impact investing provides many choices, allowing each investor to drive toward unique goals—financially and socially.

WHAT DOES IMPACT INVESTING LOOK LIKE IN A PORTFOLIO?

Because the spectrum is vast, impact investing looks different for each investor. So where to start?

“One key is to identify gaps between supply and demand for different types of impact,” says Hyzy . “The rising global demand for water, for example, creates opportunities for companies to develop water infrastructure. An impact-driven investor might seek out investments in water filtration or transportation technology. The needs presented in this scenario mirror the economy itself, which potentially makes them ripe for returns.”

For some investors, impact investing might have a more direct connection, such as micro-lending to help fledgling entrepreneurs in developing countries. Loans as small as $20 could empower large numbers of people, particularly women, in rural Bangladesh to make the leap from poverty to financial independence.

For others, it might mean investing in social impact bonds for funding expanded services needed by U.S. military veterans, or investing in companies that develop environmentally friendly technology to curb emissions and reduce carbon footprints. With so many options, it is often a good idea to start the conversation with an advisor.

HOW HAS PERFORMANCE EVALUATION EVOLVED?

In part, impact investing has gained traction due to greater availability and precision of data that focuses on environmental, social and governance issues. There are also more advanced portfolio construction techniques. The combination allows for stronger investment strategies.

“Portfolio managers, as well as institutional and high-networth investors, can now better construct and manage their portfolios using this data, thus creating a positive supply-and-demand dynamic of more users and better data,” says Snider.

A more comprehensive view of what makes a company valuable has also helped redefine performance. “The value drivers of many businesses now lie not in physical and financial assets but instead in intellectual property, market share, brand awareness and perception of the company’s impact (good and bad) on society and the environment,” she says.

For example, a company that invests in its employees and treats them well by providing quality health care, a positive office environment or other benefits will likely increase retention. That in turn boosts the bottom line by cutting the potentially massive costs of high employee turnover. “So much of the confusion in this space is thinking that you can understand the value of a company just by looking at its financials,” says Snider. “Much of a company’s value is represented by its policies and practices. We’re looking at what kind of example a company is setting in the world, and that includes everything from materials and human rights issues in the supply chain to work safety and environmental risks.” (For more, see “The Connection Between Competitive Advantage and Social Issues,” at right.)

What’s more, metrics are shifting rapidly. In 2011, just under 20% of S&P 500 companies were reporting on their corporate social responsibility (CSR) activities. By 2015, the proportion nearly reversed, with 75% publishing CSR reports.²

WHO IS DRIVING DEMAND?

Demand for impact solutions is being led by many types of investors, from institutions to women to millennials.

“Institutions have almost doubled investments with environmental criteria in the past two years,” says Snider. “At the same time, public pensions have invested $513 billion in climate change and carbon emission focused assets.”³

Demographic shifts are also leading the way. The potential $56 trillion in intergenerational family wealth expected to change hands between now and 2020—and the discussions that come along with that wealth transfer—are fostering an interest in impact investing. “We’re watching demand for a particular product start from a conversation between family members about what their wealth means to them,” says Hyzy.

The third driver is the millennial generation, those born roughly between 1981 and 1997.⁴ Eighty-five percent of millennials say social or environmental impact is important to them, and almost 60% of the youngest respondents listed “social responsibility” as one of the most important factors by which they selected investments, a percentage far greater than that of their older counterparts, according to a 2015 survey.⁵

Source: Michael E. Porter and Mark R. Kramer, “Creating Shared Value,” Harvard Business Review, 2011.

WHAT IS THE SOCIAL IMPACT OF INVESTMENTS?

Profound changes brought about by impact investing are already taking place. For example, look at womenomics, the study of the ever-expanding role of women in the global economy.

“We know women are increasingly an economic force in the world,” says Hyzy. “Look globally: In one-third of countries worldwide, girls outnumber boys in secondary school.

So we’re seeing a dramatic increase in terms of education, workforce and the marketplace.”

It’s a profound shift to think that private capital, along with government and philanthropic resources, can help solve complex social and environmental issues. But in an interconnected world, an investor in New York can help build bridges—both literally and figuratively. When investors zero in on the intersection of what matters to them and what’s needed across the globe, they can maximize their impact, both near and far. This is the next level in impact investing, and now that we’ve reached it, we expect to see a lot more growth.