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Viewpoint: How can portfolio managers navigate the risk of not achieving the desired returns in impact investing?

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Published: 6 May 2024

Should we adopt ESG investing as the modus operandi, or avoid it? Part of this debate centres around whether impact investments are achieving their desired impact, writes Better Finance’s Tenke A. Zoltani.

Tenke A. Zoltani, Better Finance: “The evidence supporting the effectiveness of impact investing has grown significantly.” | Better Finance

ESG integration does not always require avoiding at-risk companies but rather helps investors avoid companies with negative impacts on valuation and flags potential risks. An investment strategy focused on companies with increasing free cash flow and a high return on invested capital (ROIC) can also benefit from an additional layer of analysis.

Speaking of risks, energy stocks were top-performing after COVID while sustainable strategies avoiding oil companies saw lower performance and sustainable funds, which tend to have more technology stocks, fell in price in 2022. Despite this, money continued to flow into these funds, indicating resilient demand. Morningstar reported sustainable funds grew by 2.6%, while the broader universe shrank by 0.71% in 2022.

In the case of impact investing, academia continues to test the hypothesis that impact-focused funds are less volatile and offer greater downside protection. A May 2022 analysis from the University of Chicago Booth and Yale University found that impact funds’ market beta (β) was lower than the market β of VC funds and benchmarks, consistent with the less cyclical performance profile of impact strategies. This was particularly the case during the COVID pandemic and other black swan events.


Additionally, the evidence supporting the effectiveness of impact investing has grown significantly, with the results of a recent survey conducted by the GIIN in 2023 further supporting this claim. The survey consisted of over 300 impact investors across the globe, where 79% of investors reported that both their financial and impact returns either met or exceeded their expectations.

Notably, 74% of these investors were targeting risk-adjusted market-rate returns, and 88% reported that their impact performance met or exceeded their targets. The same 2023 survey highlighted that private equity had the highest gross realised returns over a three-year period, at an average of 25% and a median of 15%, among investors seeking market-rate returns.

The outperformance of both impact and ESG funds during COVID was not a one-off phenomenon. This has been reinforced by backtesting by UBS and The Economist who found that 74% of ESG-integrated investments (which did not explicitly include impact investments, but investments using ‘impact frameworks’) had better financial performance than equivalent traditional investments in the three years before 2020.

So, what are the factors convincing investors to go for impact?

First, impact funds offer less market risk exposure than VC or matched funds, making them a unique selling point for greater diversification. They outperform VC funds and perform as well as matched funds in a value-weighted long-short portfolio that accounts for market risk.

Second, ESG integration took less than three years to deliver higher returns 6 in 10 institutional investors were recording higher returns on their ESG investments compared with non-ESG investments as shown in the findings of a PWC survey conducted in 2022 . Crucially, the integration of ESG decidedly improved investment performance, according to their survey. With ESG integration often a conduit to impact investing,  proof that it can deliver higher returns over a relatively short period of time, could be a key factor in convincing investors to move into impact.  

Third, according to Pitchbook data from March this year, the worst performing impact managers in the recent past (lowest decile, 2018-2021) performed better than the worst performing non-impact managers. Investors who are not convinced about the value of impact or are not interested, could therefore still consider choosing impact managers over non-impact managers in private markets. In fact, the top decile of the impact universe has often outperformed the top decile of non-impact strategies. However, it is important to note that the medians have often been lower for impact, and selecting the right manager is crucial to success.

Finally, an even more intellectually and unarguably financially interesting opportunity lies in impact alpha generation – getting the elusive edge. While elusive, there is evidence. Impact alpha is a concept that suggests that by pursuing positive social and environmental impact alongside financial returns, investment performance can be improved for fund managers, investors, and the companies they invest in.

There are 10 drivers of impact alpha, which include factors such as attracting and retaining talent, enhancing brand reputation, and driving innovation. All of these factors can contribute to improved financial performance. However, isolating the specific financial contribution of impact alpha is difficult as it may be intertwined with other influences on investment performance. Therefore, it is hard to say definitively how much alpha is generated purely from the impact focus. Despite this, the existence of impact alpha is one reason to allocate to impact strategies.

Financial advisers have a role to play in systematically asking their clients to consider taking a small percentage of their overall investment portfolio and knowingly invest it into opportunities that are aligned with their passions and the impacts they want to create.

Just as Larry Fink from Blackrock has expressed frustration with the term “ESG” and moved away from using it, specific aspects that impact-driven investors consider, like decarbonisation, good governance, conservation or gender, can allow for a more nuanced discussion tailored to individual investment expectations.

Tenke A. Zoltani is chief impact, sustainability and ESG officer, and founder of Better Finance.

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