What Is Impact Investing? – Wealth Management

What Is Impact Investing? Wealth Management

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The ESG space is rife with acronyms and jargon. That’s a shame because the unintended consequence of careless language is full-blown confusion for investors and the public at large. Practitioners tend to be particularly sloppy in the way they use terminology, often using the same term to mean different things in different contexts. This inspires us to examine what people really mean with a term that everyone loves to use but rarely actually defines: impact.

First let’s define impact investing before we dive into how two very different asset classes tackle it. Impact investing typically refers to investments made with the intention of generating measurable social or environmental benefits in addition to financial return. An important concept in impact investing is additionality–the idea that the benefit wouldn’t have occurred absent the investment. Many in the investment world still use the term in its technical sense and reserve it for private or fixed income investments wherein it’s easier to prove additionality.

Although we recognize that many tend to use the term more loosely, in this blog post we focus on impact investing purists–investors who are looking to do impact investing under the technical definition and who want to be able to determine how their investments have directly and exclusively improved environmental and social outcomes.

Impact investing with public equities

How can you employ impact investing with public equities? The short answer is: You technically can’t, although there are still ways investors can create “impact.” The term often surfaces when it comes to reporting about, or even investing in, public equities, where the ability to attribute the effects of the investments to social or environmental outcomes is difficult at best. As a reminder, when a public equity investor buys or sells a security, the ownership typically simply gets transferred to another investor and the investment doesn’t provide new equity capital to the company. Furthermore, in the case of a follow-on offering, the new equity capital is available for any purpose the company wants. Investors can’t specify a use for their investment. That’s why public equity investors can’t precisely attribute specific social or environmental change to their investment, particularly for larger companies with diverse business lines. The investment they make lacks additionality. In other words, they can’t measure the exact social or environmental impact of their specific investment and therefore can’t say that it wouldn’t have occurred absent their investment.

This doesn’t mean that public equity investors can’t influence environmental or social outcomes, which is at the heart of “impact.” They absolutely can do this through active ownership and shareholder engagement. But this is a very different process and activity than typical impact-investing activities, such as funding new affordable housing units or solar-powered ovens. In these activities the investment creates the positive impact. However, when you invest in public equities, you can influence companies only by voting at shareholder meetings and by communicating with executives and directors to elevate the issues that matter to you.

As an example, Parametric has been pushing companies to consider more diverse boards and to encourage diversity and inclusion throughout their organizations. We believe strategic decisions should be made and overseen by a diverse group that will afford a broader range of perspectives. That’s why we wrote to 144 companies with all-male boards in the Russell 3000(R) in 2020 asking them for a dialogue to better understand the hurdles that stood in the way of more gender diversity on their boards.

A year later we were pleased that more than 70% of the companies that we’d contacted had added at least one woman to their board. We know that we weren’t the only ones pushing for these changes, but lending our voice made a difference. This is not an example of impact investing, but it does show the power of shareholder engagement and the influence investors can have.

Impact investing with municipal bonds

So how can you do impact investing with municipal bonds? It’s an entirely different story in the municipal landscape when it comes to use of proceeds. In the municipal bond market, most bond issues finance projects that serve the public good and provide some kind of community benefit by the sheer nature of the asset class. However, when you look at the use of proceeds of municipal bond issues, it’s clear that some bond issues serve a more meaningful social or environmental purpose than others. Investing in these municipal bonds can directly fund projects that seek to improve social outcomes–schools in underserved communities, renewable energy projects using solar or wind power, or replacing water and sewer systems to deliver cleaner and safer drinking water. By focusing on issues with a positive community impact, investors can direct more capital and lower borrowing costs to issuers that are doing good and divert resources from issuers that are doing more harm from a social or environmental perspective.

As part of the investment process in an impact-investing strategy, it’s important to track the use of proceeds on an ongoing basis. This helps investors make sure that the issuer is using the bond proceeds for the purpose disclosed at the time of issue and that there are no detrimental social or environmental consequences as a result the project. Through this due-diligence process, investment managers can maintain the integrity of impact-investing vehicles and ensure the investments are truly improving societal outcomes.

Although bondholders don’t have the same proxy-voting rights as equity shareholders, engagement in the municipal bond market functions through open dialogue between the issuer and investors. Bondholders may highlight material environmental or social risks the issuer should address. Municipal bond investors also use the engagement process to encourage better ongoing reporting and disclosure practices from issuers to encourage transparency in the market regarding these environmental and social risks.

The bottom line

While the term impact investing should be used carefully in the public-equity space, it’s particularly applicable to municipal bonds that directly finance projects that seek positive social and environmental outcomes. Additionality is an important nuance in impact investing strategies that routinely gets brushed aside. But don’t despair–if you’re looking to influence organizations to become better corporate citizens, you can always look to engagement to make a difference regardless of the asset class.

It’s not necessarily easy, but it’s a worthwhile exercise. According to the United Nations Principles for Responsible Investment, active ownership is one of the fastest-growing investment strategies in globally listed equity and is “regarded as one of the most effective mechanisms to reduce risks, maximize returns, and have a positive impact on society and the environment–for passive and active investors.”