Why Investors Should Practice Impact Investing

Impact investing is an investment discipline where institutions or individuals consider environmental, social, and corporate governance criteria when selecting which firms to invest in with the goal of generating positive financial returns and societal impact. In recent years, the percentage of investors wishing to implement social responsibility into their investments has increased. According to Morgan Stanley, millennials are practicing impact investing at a rate 2x higher than average (Morgan Stanley, 2017). With a $30 Trillion wealth transfer predicted in coming decades as Baby Boomers retire and their heir inherit their savings, this trend is only going to increase, but a critical question remains, does employing environmental, social, and governance restraints actually have a positive impact on investments in terms of their respective returns, risk management, and strategy?

As years go on, an increasing number of investors are assessing whether or not to invest in companies based on environmental, social, and governance factors (ESG). According to the Wall Street Journal (2018), the graphic below shows how from 2005-2016, sustainable investing in the U.S grew exponentially.

These considerations can have both a positive and negative impact on a firm’s financial performance and consequently creation of shareholder value. Recent studies have shown that companies with high levels of ESG implementation are actually more likely to provide high financial returns and minimize risk, especially when the public markets are becoming more volatile. Not only can it minimize risk and maximize returns, but it also aligns the investors strategies with their personal priorities, or in the case of an institutional investor, align the strategy with the priorities of its investors and stakeholders. Based off these conclusions, this paper will show why investors should rationally consider making their investments more ethical.

Enhance Returns

The Wall Street Journal did a survey of American investors that concluded that 59% of investors believe that sustainable investing involves a tradeoff when it comes to returns. However, a lot of current research on sustainable investing concludes that if there is any effect on returns by using ESG constraints, that it is positive. Studies done by Mckinsey (Desjardins, 2017) show that sustainable investing and above average financial returns had a positive correlation. A collaborative study, shown on the left, done by the Wall Street Journal and Morgan Stanley also concluded that in the long-term, SRI investments (short for socially responsible investments, shown in green) outperform non-socially responsible investments (shown in gray). Not only has a positive correlation been found, but studies have also proven that low financial performance and sustainable investing are uncorrelated. Based off this information, one can conclude that investors should consider using ESG constraints when designing their investment strategy as it can increase the like hood of them producing market-rate returns, if not greater returns, compared to other investment strategies.

Risk Management

When analyzing recent events that have destroyed shareholder value, and therefore negatively affected financial performance one can see that often times an initial investment in the company could have been avoided had ESG constraints been leveraged. Worker safety, waste spills, and other environmental, social, and governance catastrophes have caused serious harm to companies. Though ESG scoring methodology varies depending on the agency doing the rating, the same end goal is uniform across the industry. A reporting agency evaluates a company (usually on an annual basis) by collecting publicly disclosed ESG information. The data’s accuracy is ensured and then standardized for comparison. The major ESG ratings cover around 120 environmental, social, and governance indicators such as: climate change effect, waste disposal, supply chain, human rights, and community relations to name a few (Huber, 2017).

Taking into consideration a longer time horizon, how companies approach issues such as climate change and water scarcity may also have massive implications in the future. MSCI, a leading provider of stock market indexes, conducted research in 2017 (Giese, 2017) that concluded that companies in the lower percentile of ESG scores have been 2x as likely to suffer catastrophic losses (over 95% cumulative loss) within three years. Therefore, by implementing ESG constraints an investor, or a group of investors can greatly reduce their risk of being significantly impacted by potentially negative market events.

Additionally, Morgan Stanley’s 2015 Sustainability Report which surveyed over 10,000 mutual funds found that socially responsible investments had lower volatility than comparable non-impact investments. Therefore, investors looking to minimize the volatility of their portfolio can leverage impact investments to do so. In a day and age where markets are rather volatile, minimizing the volatility of a portfolio is often heavily desired by investors. Since 1990, the environmental and socially conscious Morgan Stanley Capital International KLD 400 index (ticker DSI) has not only outperformed the S&P and market cap-weighted index during bear markets (when the overall market is going down), but also during bull markets (when the overall marketing is going up).

Strategy Alignment

Recent market data has shown that the demand from investors, whether personally or through an institution, for strategies which implement ESG constraints has grown year over year. This can be tied back to the growing media focus on environmental and sustainability topics, as well as recent event such as the BP oil spill which have highlighted the damage corporations can cause when mismanaged. These strategies are especially important for the younger generations, with nearly 67% of high net worth millennials agreeing with the statement “My investment decisions are a way to express my social, political, or environmental values” (US Trust, 2018). One can assume that as more and more of the younger generations join the markets, that the level of ESG usage will increase due to their desire to do good for the planet and society by only providing capital to firms which are focusing on societal and environmental sustainability.

As workers increasingly have a say in how their pension or retirement fund is invested, there is an opportunity for aligning the respective investment strategy with their personal values. It’s proven that conscious consumerism is on the rise. An increasing amount of people are mindful of the