Impact investing is a strategy that seeks to create a specific positive impact or outcome. What sets it apart from pure philanthropy (like cash donations) is that impact investing includes an expectation of financial returns that are (at least) comparable to market returns.
Categories of intended impact include (but are not limited to) those that are social in nature, like access to education or employment opportunities; environmental, like reforestation projects or clean energy initiatives; as well as health-related, such as wider access to medical care, clean drinking water, or addressing agricultural issues.
Impact investing is not limited to any particular asset class (such as stocks or bonds); in fact, impact investing strategies may include private equity investments, project finance initiatives, or even microfinance loans to support small-scale entrepreneurial ventures in underbanked populations.
Impact investing is a style of investing where a clear and positive outcome (social, environmental, etc.) is prioritized alongside financial return expectations.
Impact investing is not the same thing as ESG investing, though there are some common threads.
Impact investing is often conducted by retail investors through professionally managed funds (e.g., mutual funds and ETFs); however, direct investment in impact-oriented projects or even micro-finance initiatives is also common for accredited investors.
Understanding Impact Investing
Impact investing can mean many different things and can be characterized in a variety of ways. But for a capital allocation decision to qualify as impact investing, two important hurdles must be cleared. These are:
A positive impact is clearly articulated and outlined; and,
A financial return expectation (at least comparable to the market) must be intended.
Some specific examples should help illustrate.
Let’s say you live in a densely populated and expensive urban center that is in desperate need of affordable housing. Assume that A) you have some excess capital, and B) you wish to deploy some of that capital towards supporting affordable housing.
There is an opportunity to donate funds to a local charity that supports affordable housing projects.
This is NOT impact investing (in fact it’s not investing at all).
There is a local developer seeking private loans with interest rates that are lower than the US Treasury rate, to defer some of their construction costs.
This is NOT true impact investing as the return expectation is clearly secondary.
That same developer offers an opportunity for you to invest in a limited partnership, the proceeds of which will support the construction of affordable housing. It is expected to generate market (or better) returns.
This IS impact investing as there is both an intended positive outcome and a clear financial return expectation.
Impact Investing: Performance
To qualify as impact investing, there must be a return expectation that is in line with or greater than that of the market. Of course, expected returns do not necessarily lead to actual returns.
Below is a three-year chart of two impact-focused, thematic funds. These have been compared against the S&P 500 return (denoted in blue).
The green line represents total returns for the SPDR SSGA Gender Diversity Index ETF (ticker: SHE). SHE is a fund dedicated to female empowerment; it holds shares in over 180 companies that are advancing women to senior executive positions at greater rates than the broader market.
The red line represents total returns for the First Trust Water ETF (ticker: FIW). FIW is a fund focused on all things water, including investments in businesses that are advancing initiatives related to purification and the equitable distribution of potable water, to businesses that are innovating in the wastewater space.
In spite of investors hoping for (at least) market returns, FIW outperformed while SHE lagged the broader market.
Impact investing often focuses on improving environmental or social outcomes, which is part of peoples’ confusion. But impact investing is not ESG.
ESG is an analysis framework that helps stakeholders understand and manage risks and opportunities within an organization (or a portfolio).
And while this framework is often applied to investment decisions and/or analysis (called ESG investing), it’s not the same as deploying funds with the express intention of generating a positive externality or impact beyond the four walls of the organization itself.
What is ESG investing?
ESG investing is when an investor makes capital allocation decisions based upon their understanding and analysis of specific environmental, social, and governance factors or assessment criteria.
ESG investing strategies depend largely on the fund’s ethos, but techniques may include negative screening (like no companies in the oil and gas sector), positive screening (only companies with a human capital management score of X or greater), or thematic investing (only looking at companies or projects in the clean technology sector).
Thematic investing is an area where impact investing and ESG have some crossover. For instance, our examples earlier (SHE and FIW) are funds with impact-oriented, thematic underpinnings.
Many institutional investors and financial services companies have constructed both impact and ESG funds, which have mostly taken the guesswork out of values-oriented investing for everyday, retail investors by allowing them to purchase mutual funds and ETFs that align with their own beliefs (many of which are E, S, or G-themed).
What are the key differences between impact investing and ESG?
The biggest thing to understand about impact investing is that there is an intended positive outcome (the impact).
ESG investment decisions tend to be made not with a specific impact in mind, necessarily. ESG investors believe that companies that perform better against environmental, social, or governance metrics are better investments. This is either because management is more aware of specific risks (and can mitigate accordingly) or because they’re better positioned to capitalize on opportunities that may emerge from changes to social norms or environmental realities.
All things being equal, many ESG-centric investors care about values and about making an impact in the world, but their capital allocation decisions are influenced much more by risk and opportunity management than they are expressly by impact.
Whether you’re an impact investor or an ESG enthusiast, you likely believe in two important principles. These are:
That completely unchecked capitalism in its current form isn’t working for a large number of stakeholders – these include but are certainly not limited to supply chain partners in developing economies, employees, and even customers. And,
That the management teams of organizations seeking capital (either public companies, private project developers, or early stage founders) owe the market greater transparency and accountability around what (if anything) they’re doing to promote positive change from the status quo.
This article was prepared in collaboration with Rho Impact.