As more people become aware of impact investing, advisors and investors both are looking for smart ways to incorporate it into portfolios.
Some people simply see it as a “sleeve” in their investments—yet another strategy within a larger, diversified portfolio of investments.
But that approach has given way to another in which the entire portfolio is scrutinized for impact, as well as risk and return.
The approach is called “total portfolio management.”
It’s a timely subject for financial advisors, who are increasingly called upon by their clients to structure investments in way that accords with social and environmental well-being.
The idea behind this approach is that it optimizes diversified financial returns while also maximizing impact for a given asset class. It is not “reductive.” In other words, it doesn’t look to screen things out so much as enhance the portfolios. It asks how investors might take traditional investments and augment them with better analytics to consider both off-balance-sheet risk and impact investment opportunities. So the approach puts the fundamentals of traditional investment management front and center in every investment decision.
It also considers the full array of an asset owner’s capital, including philanthropic monies and near-market investments as well as market-rate investments. Such an approach acknowledges that charitable giving—by providing donors with tax benefits and other considerations—offers financial value while generating social and environmental returns. It also shows that market rate investing can generate social and environmental value, too.
It’s a holistic approach to generating the full, blended value advisors and clients seek as they manage and deploy their capital resources.
Step 1: Establish Goals and Objectives
The first step in any investing is to define the investor’s goals for his or her assets, including retirement, college expenses, wealth preservation for the future, as well as any unique cash flow needs a client has over time. This familiar process is equally important for building an impact portfolio. Just as they would approach return expectations, advisors must explore clients’ expectations about the social and environmental impact of an asset. Each client will have a unique agenda. A discussion about values more closely aligns the advisor and client—because it’s critical that an advisor understands the client’s reasons for creating such a strategy. Knowing that will advance the impact investing goal.
Step 2: The Investment Policy Statement
The investment policy statement is also critical for clients who want their entire portfolio to have an impact basis. It is the framework used to evaluate the total performance, not just the excess return on an investment.
Crafting this type of statement may be a challenge for advisors taking their first steps in impact investing. Despite the substantial evidence that impact investments deliver market-rate returns, many advisors and investment committees are resistant to change, mistakenly believing that investing this way threatens performance—and thus fiduciary obligations.
The statement is a dynamic document that should be revisited annually and modified as markets shift or investor intentions evolve. Changes to the statement should not be undertaken lightly.
A statement can include several pages of narrative on the nature of the impact wanted, or it could address impact in a few paragraphs. Either way, it is critical that the statement explore the impact question with enough clarity to guide the wealth advisor in his or her decision-making.
A Possible “On Ramp” to Total Portfolio Management:
Some clients begin their journey by taking a portion of their investment portfolio and allocating it to themes or strategies—whatever the advisor and client agree to “carve out.” This capital may be invested in a single asset class or distributed across asset classes with specific themes.
A staged, incremental approach may make fiduciaries more comfortable—it may also be required if there are existing investment lockups or taxes. Even investors seeking to go “all in” on impact investing will find it is not a process that takes just a few months but actually a year or more.
Step 3: Asset Allocation
Since each asset class has its own risk and return, advisors must customize portfolios to fit specific objectives.
An advisor who thoughtfully integrates impact will evaluate where impact investing is redundant, complementary or catalytic in certain investments relative to the ultimate objectives of the investor’s entire portfolio. The returns may vary within the portfolio, but it’s the financial and social impact of the total portfolio that matters.
Manager Search, Due Diligence and Selection
After the asset allocation is established, the process of researching managers, conducting due diligence and selecting investments may begin. As with all other investment products, specific diligence requirements differ with asset class.
But it is always important to take a close look at the people, process and philosophy behind an impact investment, as well as the performance (including impact). It is also critical to analyze the manager’s impact reporting capacity and practices as well as its traditional financial management practices.
Step 4: Performance Monitoring
Ongoing monitoring and evaluation is especially critical for a portfolio that is actively designed to generate positive impact. It’s also important to review performance against benchmarks amid changing client circumstances or market conditions. An advisor who takes a formative approach to portfolio monitoring will compare actual outcomes to expected outcomes, highlighting both the strengths and weaknesses of an investment strategy. These insights inform potential revisions that will need to be made to the portfolio strategy to better meet client objectives.
This is a unique opportunity for advisors to create value within the investment relationship and strengthen it—because they come to understand clients’ values.
Conclusion
Investors are increasingly aware of both the positive and negative impacts that may be generated through the investment of financial capital. And a growing community of investors, as well as a robust body of research, concludes that there is no trade-off that has to be made when advisors are considering financial returns and risk management against social/environmental impact.
While impact investing may seem new, the impact products available in every asset class are growing rapidly. A total portfolio approach is far more accessible than it was even 10 years ago and leading investors are providing the proof that impact investments are not an asset class, but rather an overall approach to maximizing the total performance of a portfolio.
Jed Emerson is chief impact strategist at ImpactAssets and Lindsay Smalling is director of programming at Social Capital Markets.