The core terms: Impact and additionality

First, I explain the most important terms in this context: So-called impact investing is typically about making a positive impact with the investment of money. For example, financing can be used to build a new hospital, a school, a renewable energy supply or similar projects.

In contrast to donations, it is expected that the invested money is returned. In addition, positive returns should be achieved. However, the expected returns are often lower than those of traditional investments.

It is usually also expected that the additional benefit of the investment is quantified. The aim is to achieve so-called additionality or additional social or ecological returns. Measuring such non-monetary returns in additional hospital beds, doctors, school children, solar plant capacity etc. is relatively simple.

I call this concept Absolute Impact Investing (see Positive Impact Investing by Karen Wendt).

Absolute Impact Investing and open funds

Absolute Impact Investing usually is offered directly in the form of illiquid project financing or indirectly via illiquid closed-end funds. Moreover, such absolute impact investments are typically hardly diversified. However, investors do expect attractive returns on these investments.

In recent years, more liquid and diversified investment structures such as microfinance funds have also been available. For such investments the expected returns are relatively low.

Recently, more and more open-ended investment funds have been coming onto the market that carry Impact or SDG in their name. SDG stands for the 17 sustainable development goals of the United Nations. These funds typically seek similar returns and comparable risks as traditional investments and also offer high liquidity. They therefore achieve something positive in terms of SDG without disadvantages for investors. That sounds very good. But with „too good to be true“ approaches one should be sceptical.

Unsurprisingly, some sustainability experts are critical of such funds. Their main criticism typically is that the funds mainly invest in listed stocks and bonds. This would mean that the funds would only buy shares or bonds from other investors which would not lead to any additional social or ecological benefits, i.e. no additionality.

This criticism is basically justified. However, the providers of such funds also rightly point out that an increasing demand for so-called impact shares or impact bonds would make future financing easier for the companies behind them. Higher share prices can make it easier and cheaper to raise additional equity capital. Additional demand for credit can increase the available credit volume and reduce financing costs. However, such effects are hardly measurable directly or cannot be directly attributed to the impact investors.

Traditional critics also point to the relatively limited investment universe of such funds. Their main criticism is typically that such funds could not generate attractive returns or that they would take on too high (concentration) risks. I do not know any meaningful statistics on this. However, my own experience with such investments has been very positive since the launch of my corresponding portfolio in 2017.

Therefore, neither of these arguments are sufficient reasons to reject liquid impact investments in equities or bonds.

Relative Impact Investing

I even consider liquid impact investments to be particularly attractive. Many investors would like to invest a large part of their assets in liquid assets. Why should they invest their money in shares of arms companies, fossil energy producers, soft drink producers or similar companies?

Instead, they can invest in shares of health care companies, producers of renewable energies, etc. While this does not produce an easily measurable absolute positive impact, I believe they have a positive relative impact compared to traditional equity and bond investments. Therefore, I call this approach Relative Impact Investing.

Sector-oriented Relative Impact Investing approach

However, it is difficult to find listed companies that can have a positive impact on the United Nations‘ SDG. Ideally, investors want to have stocks in their portfolio that have a 100% positive impact. But there are only a few companies that publish the positive SDG impact on their sales or capital investments (CapEx) and a negative or neutral SDG Impact as well. Only if one has these numbers, one can calculate a net SDG effect. And only the net SDG effect is decisive for a classification as Impact or SDG Investment.

When I developed my first liquid impact model portfolio in 2017, I therefore chose a segment approach. In particular, I define health care, infrastructure, renewable energies and water supply and waste disposal as being fundamentally SDG-compatible.

However, according to my definition, licensed healthcare companies are not allowed to use genetic engineering or animal testing. And infrastructure companies are only included in the portfolio if they have a rail or telecommunications focus. „Fossil energies“ are on my exclusion list, and fossil-fuel-heavy airport and motorway operators are hardly likely to work in the spirit of promoting the 17 SDGs.

Furthermore, I only want to include companies in such a portfolio that also meet my typical minimum requirements in terms of environmental, social and governance criteria. Specifically, the companies permitted must be among the top 50% in each of these criteria in order to be included in my impact portfolio (see https://prof-soehnholz.com/impactesg-innovatives-mischfondsprojekt-der-von-der-heydt-bank/).

Relative impact is difficult to measure

This ESG + impact approach is well received by interested parties. However, I am often asked whether the absolute impact of this portfolio can somehow be measured. But this is difficult for several reasons.

First of all, we have checked whether any of the information provided by our data provider Refinitiv is helpful. On the positive side, there are more than 50 data fields per share that can somehow be assigned to one of the 17 SDG targets. This includes answers to questions such as „Does the company have a policy to avoid the use of child labor?”. But a yes or no answer to these questions does not help much. Because if you produce completely only in Germany, you probably don’t need such a policy. And if you have such a policy, that doesn’t mean that it is good and that it will be followed.

Other data fields are easier to evaluate, e.g.: „Total community lending, financing and investments which are not considered donations“. However, many companies apparently do not provide reliable data for this.

We still have been able to identify a number of key figures that we believe are suitable for impact measurement. These include emissions, resource use, diversity, inclusion and people development scores.

Selection versus measurement criteria

However, these scores are subcomponents of the environmental and social ratings that we already use to select the securities for our impact portfolio.

For the selection of equities and bonds, we have already decided on separate minimum values for the E, S and G scores in 2016. With our requirements that the E, S and G scores must be among the top 50%, our portfolios have usually been very successful to date. Together with minimum liquidity requirements and many and strict exclusions, only just under 70 shares will meet all our requirements in 2020. Additional minimum requirements, for example in relation to the above-mentioned subscores for inclusion, would probably reduce our investment universe too much.

We plan to review our selection criteria at the end of the year, as we do every year. To this end, we have already found a good way to expand our permitted ESG + impact universe without relaxing the impact or ESG requirements.

Criticism of so-called ESG and impact progress and momentum approaches

We can certainly measure the progress of our portfolio companies in terms of E, S, G and/or the subscores mentioned above such as diversity. However, it is quite possible that the progress is relatively small. The reason for this is our high minimum selection requirements.

Furthermore, measuring changes only really makes sense if you want to derive actions. It is obvious to prefer an investment that enables the greatest possible progress, for example in terms of resource use. Companies that have done very little in this area so far can probably achieve significant improvements relatively quickly with a relatively small investment. On the other hand, firms that have already greatly improved their resource use in the past are likely to have to invest relatively heavily to achieve further small improvements.

But should investors who want to achieve a lot of impact improvement invest in „bad“ companies? Should they even withdraw money from „good“ companies in return? I prefer to invest my money in particularly good companies and not in those that have done little social or environmental work in the past.

I am similarly critical of so-called ESG momentum investment. With this approach, preference is given to investing in companies that show initial progress in improving individual or aggregated ESG scores. This approach also has a strong tendency to invest in relatively bad companies. In addition, these companies are also deprived of investor capital once they have become good, so that this capital can be invested in low-ESG Momentum stocks. I do not find such punishment of good companies worthy of support (see https://prof-soehnholz.com/taxonomy-for-responsible-investments-avoiding-greenwashing/).

Relative impact measurement cannot hurt

Even as an investor in already particularly good companies, you can measure the change in ratings. The question here is what consequences deteriorations have.

As with ESG and E, S and G ratings, it is unlikely that diversity, inclusion, etc., will change significantly in the short term. Moreover, since such ratings are by their very nature imprecise, it is not necessary to react with divestment if the deterioration is relatively minor. However, in the event of significant negative changes, the corresponding share or bond can be removed from the portfolio and replaced by a better-rated security. The questions are how a major change is defined and how often to trade.

For the Impact + ESG model portfolios of my company Diversifikator, the reviews and changes are typically done only once a year. The ratings of the companies in the provider’s database are typically evaluated at least once a year based on data reported by the companies. I only include securities of companies in the model portfolio if the minimum ratings are met. All others are dropped from the model portfolio accordingly. The more ratings are reviewed, the greater is the portfolio reallocation due to rating changes. In my case, explicit E, S and G minimum ratings must be met simultaneously, so that good governance, for example, cannot compensate for poor social behaviour. If I would use minimum requirements for additional criteria such as people development, the portfolio’s turnover would increase. As with other portfolio providers, large investors can commission ongoing monitoring of the portfolios and do not have to wait until the next selection date before making changes to the portfolio.

A second ESG rating provider can also be called in for monitoring purposes. This can be useful because ratings can vary considerably depending on the provider. The following also applies here: more criteria often mean lower requirements per criterion, so that sufficiently diversified portfolios can still be put together.

Using self-implemented model portfolios from Diversifikator, even retail investors can cost-effectively implement more frequent monitoring using the free public ESG ratings from MSCI.

Combining Relative Impact Investing and Absolute Impact Investing

The ESG + Impact portfolio of Diversifikator, which was compiled according to these rules, has performed very well since its 2017 launch. In my view, it has a relatively positive impact compared to traditional and also compared to other ESG portfolios. However, the absolute impact cannot be measured reliably.

Absolute Impact Investors who attach importance to the measurability of impact must reduce their expected returns (example: microfinance funds) or take higher liquidity and concentration risks (example: project financing) than Relative Impact Investors.

One can also combine both approaches. If you donate well in addition, you will probably do little wrong.

(Mainly translated by Deepl)