By Matthew Weatherly-White
Doing well as investor by doing good
One of the trendiest -- and perhaps least understood -- emerging disciplines in financial markets right now is "impact investing." This is the allocation of capital to generate a positive financial return in addition to creating measurable, durable social and/or financial value. Some recent examples:
* BlackRock (BLK) recruited Deborah Winshel from The Robin Hood Foundation to drive an impact mindset throughout the company -- reflecting CEO Larry Fink's provocative (and inspired) letter to his fellow S&P 500 CEOs regarding climate change and the evils of short-term thinking.
* The Ford Foundation publicly committed to (eventually) convert 100% of its $12 billion endowment to impact investing.
* The Bill & Melinda Gates Foundation, in a surprising reversal, has begun to strip its portfolio of carbon exposure and to make impact investments.
* This year's World Economic Forum at Davos (http://www.marketwatch.com/story/davos-thinks-it-runs-the-world-but-populism-begs-to-differ-2017-01-18)focused on inequality around the globe.
* Even Pope Francis suggested in his second encyclical (http://www.marketwatch.com/story/pope-delivers-strong-message-on-climate-change-2015-06-18-91035726) Laudato Si that capital markets should bend towards impact investing.
But what does all of this really mean? Will Wall Street and the global financial markets suddenly decide that the business of business is social responsibility and environmental sustainability?
Not likely. But nevertheless, asset managers and wealthy families are pursuing what is known as non-financial return. And they are doing so in part by de-coupling two conflated concepts: "values" and "materiality."
Many mutual funds incorporate SRI (Socially Responsible Investing) or ESG (Environmental, Social/Sustainable, Governance) factors from a values perspective. These funds utilize what is essentially an activist approach to capitalism: screening portfolios either positively or negatively to map and reflect investors' values.
Examples include funds that avoid so-called "sin stocks" including tobacco and firearms manufacturers, or prefer companies offering progressive maternity and paternity leave benefits, or invest in companies specifically seeking to reflect gender or race diversification among their employees. While investment merit is obviously an important driver for security selection, values alignment can be equally important, leading to portfolios based on factors beyond purely financial gain.
Materiality, on the other hand, is anchored in the idea that specific risks or opportunities can be identified through sophisticated ESG analysis. This analysis can discount as obvious a risk as the imposition of a carbon-pricing mechanism, or as subtle as the importance of gender and race diversity in the boardroom, C-suite, and the employee base.
The accumulating evidence is compelling. Consider:
* The KLD Social Index has performed in-line with the S&P 500 for more than 25 years.
* Investment firm Generation Investment Management -- one of the market's most vocal proponents for the materiality of ESG factors -- has outperformed its benchmark by five percentage points, compounded, for over a decade.
* The cost of capital to finance renewable and alternative energy projects (http://www.marketwatch.com/story/low-carbon-etfs-catch-a-spark-in-trump-era-2017-02-08) has dropped dramatically over the last decade, shifting risk perspectives towards these assets.
* Aperio Group, a manager of customized index funds, has clearly demonstrated, with billions of deployed dollars, that there is no required financial trade-off when pursuing narrow ESG themes.
The evolution from "values" to "materiality" is an indication that the entire discipline of social and environmental investing is growing up. This maturation is reflected in the investment activity among some of the world's wealthiest families and largest asset managers.
ESG factors have begun to be braided into core investment disciplines. Understanding, pricing, and mitigating risk. Identifying opportunity. Investing in businesses that offer products and services addressing consumer demand. These are foundational activities for any investor. That SRI/ESG factors are now integrated on the same level as enterprise valuation, free-cash-flow, and operating margins suggests that impact investing is likely to become more prevalent.
In other words, incorporating ESG factors has been proven to be good investing practice.
Many investors would disagree. They believe, with defensible logic, that the function of the markets is purely commercial, leaving social or environmental concerns for philanthropists and governments. They can cite historically disappointing SRI performance as the rationale for this perspective.
But philanthropic capital is insufficient to tackle the great challenges we face, and tax-based budgets are stretched and government policy frequently allocates capital poorly. Accordingly, institutions and other forms of private capital --wealthy families, sovereign wealth funds, pension funds -- must get on board.
Climate risk is a good example. Regardless of one's political orientation, and regardless of who sits in the White House, the science around climate change is grounded. And while the Paris Climate Accord lacked teeth, it provided direction. The world's governments have committed to some form of concerted action to combat the risk of climate change.
Doing so will be incredibly frustrating. Political will is monstrously difficult to harness. Administrations change, capital flows are difficult to predict. Yet existing industries will be reshaped and redefined from within, regardless of policy. Case in point: there are more workers in the U.S. solar industry now than in oil and gas exploration and production or coal. This is an inevitable and irreversible market dynamic -- and markets always trump politics.
Periods of rapid transition offer one thing for investors -- opportunity. Yet in the heady rush to institutionalize impact investing, thought-leaders in the discipline are beginning to hesitate. So much attention has been paid to the "how" -- deal structure, incentives, measurement -- that the "why" is being marginalized. This is a real and entirely different risk. After all, the whole point of impact investing is to harness the power of the capital markets to address some of the world's great problems. In the battle for market share and the rush to scale, the moral motivation may be lost.
As one inheritor of a large fortune put it recently: "How one deploys capital can no longer be considered an activity stripped of morality." The question then becomes: How will the capital markets, long trained to ignore the social or environmental consequences of its activity, internalize this new (moral) normal?
One thing is certain: At a time of rising climate risk and growing recognition of the corrosive effect on societies from inequalities in income, wealth, and opportunity, impact investing won't be silenced.
Matthew Weatherly-White is managing director of The Caprock Group, which advises wealthy investors on impact investments.
-Matthew Weatherly-White; 415-439-6400; AskNewswires@dowjones.com
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02-13-17 0519ETCopyright (c) 2017 Dow Jones & Company, Inc.