There was a time when investors were happy to take a hands-off approach and let their advisers or a professional fund manager handle their portfolios and specific investments. The individual assets or equities were of little concern as long as they performed. This strategy obviously worked well, as baby boomers have amassed more wealth than any generation in history.
Now, as members of this generation are entering their 60s and 70s, they are beginning to pass that wealth down to their children. According to Cerulli Associates estimates, nearly 45 million U.S. households will transfer a total of $68.4 trillion in wealth to heirs and charities during the next 25 years. That’s an average of $1.52 million per household. It’s more than three times the U.S. annual GDP of $20.5 trillion. Any way you look at it, that’s a lot of money changing hands.
But it’s more than money changing hands. The attitude attached to that money is also changing. The generation on the receiving end of this largesse is much more concerned with the types of investments populating their portfolios than their parents were. They want their investments to line up with their values, and they want to make an impact.
ENTER IMPACT INVESTING
The term “impact investing” was coined in 2007 by the Rockefeller Foundation. Though it started slow, the sector has seen exponential growth in the past few years as the millennial generation began to make its investment preferences known. The Global Impact Investors Network (GIIN) estimates that, as of the end of 2018, there was $502 billion in impact investing assets worldwide. Back in 2015, respondents to the GIIN survey reported just $35.5 billion AUM. Morningstar data also illustrates the steep upward trendline of impact investing. During 2019, almost $20.6 billion of new investment flowed to ESG mutual and exchange-traded funds. This is up from $5.5 billion just the year before — a nearly 400 percent increase.
“We’re seeing the interest increase particularly in the foundation and endowment world,” says Brad Harrison, managing director at Tiedemann Advisors. “Those entities have a charitable purpose or mission that lines up with the ethos of ESG and impact investing. If they are already distributing 5 percent or more of their portfolio for philanthropic endeavors, it makes sense to tilt the ‘other 95 percent’ of the portfolio the same way, significantly leveraging their charitable intent. We are also seeing an increase among high-net-worth taxable investors, as the huge generational wealth transfer of assets begins to flow to millennials, who have shown a strong propensity for impact investing.”
Despite the increase in capital flows, value-based funds are still a very small part of the $22 trillion mutual and exchange-traded fund market, though they are having an outsized impact.
“If a manager is choosing between two funds, all things being equal, he’s going to choose the ESG fund over one that isn’t because his investors are going to be happier with that,” says Daniel Catone, founder and CEO of Golden State Wealth Management. “It’s a deciding factor.”
WHAT IS IMPACT INVESTING?
Impact investments, as defined by GIIN, are investments made with the intention to generate positive, measurable social and environmental impact alongside a financial return. Impact investments are made in both emerging and developed markets, across all asset classes, in public and private markets. The term impact investing is often used interchangeably with socially responsible investment (SRI) and environmental, social and governance (ESG) criteria, but it differs in that it is more proactive. Investors want to make a purposeful positive impact as opposed to merely avoiding a negative impact.
This means they aren’t simply screening out stocks that involve tobacco or animal testing or poorly diversified boards. Instead, they are choosing specific sectors that positively affect a community, such as green energy, affordable housing, sustainable agriculture and timber, accessible water, and healthcare facilities, to name a few. Screening out negative features, such as companies that pollute the earth or produce unhealthy products, results in an alignment of values, but it doesn’t have the same impact as investing in firms and industries benefiting a community.
ACCESSING OPPORTUNITIES
The best intentions in the world will fall short if there is not a relatively easy way to execute on them. Today’s investor has it easier than those in the past, as mutual funds and ETFs with multi-year track records are making it easier than ever to invest even small amounts of capital. For investors looking to invest in specific sectors, professional managers are now offering strategies and vehicles that focus on affordable housing, financial inclusion, climate change and clean energy to name just a few. For example, real assets investors can invest with social-purpose REITs, such as the Housing Partnership Equity Trust or the Community Development Trust. They can invest in REITs such as Reven housing REIT, which invests in moderate-priced housing, or several manufactured housing REITs. The Iroquois Valley Farmland REIT invests in organic farms. Investors can also find digital banks, low-minimum funds and donor-advised funds that make it easier for people to integrate impact into all aspects of how they transact. The offerings are proliferating, and advisers are scrambling to keep up.
“I don’t know a single adviser who is not interested in the space and providing options for their clients,” says Catone.
One of the strategies management advisers are using to meet their clients’ demand is Total Portfolio Activation. This is a strategy that uses impact, ESG and/or SRI principles to guide their choices on every investment within the portfolio, including cash. The idea is that a single investment might have a measurable impact, but an entire portfolio based on impact principles will have an exponential effect.
“There are three steps that allow us to overlay impact strategies across the client’s entire portfolio,” explains Harrison. “First of all, we can look at an investment through a values-aligned lens. This simple approach screens out bad actors and tilts toward good ones, ensuring the portfolio is initially aligned with the client’s values. Secondly, we can employ actively managed ESG-integrated investment strategies. For example, we can invest in opportunities where the financial performance is linked with the social and environmental performance – when one does well, so does the other. Thirdly, we target highly thematic investments in private markets that advance specific outcomes, such as investing in high growth businesses that utilize artificial intelligence, biotechnology, and the rapid advancement of fintech platforms. And importantly, we don’t overlook the role of community banks as an alternative for cash allocations.”
JUDGING A GOOD INVESTMENT
Investors and managers often ask if impact investments are “just as good” as other investments, meaning do they have to give up performance to make a difference. And, in fact, it has been widely believed for years that investors did, indeed, give up some return in exchange for doing good. Because they were choosing from a smaller universe, it was assumed they were probably missing some of the best companies.
“We know now, after tracking these investments for years, that isn’t true,” says Catone. “In fact, it is better for business to be environmentally, socially and governance conscious. You don’t want to be investing in a company that is shut down because it polluted the city’s water supply or because the products it sourced from non-regulated countries were contaminated with carcinogenic materials.”
The UBS/Campden Wealth Global Family Office Survey 2019 reported that for the vast majority of family offices, their impact investments have matched (61 percent) or outperformed (20 percent) expectations, compared to their comparable traditional investments during the past 12 months.
“I know through personal experience that you do not need to trade impact for return,” says Jim Sorenson, founder of the Sorenson Impact Foundation and co-founder and managing partner of Catalyst Opportunity Funds. “Two years ago, I took a leap of faith to leverage the foundation’s balance sheet into Mission-Related Investments (MRIs). By most standards, our mission-alignment process has gone at lightning speed: We are over 75 percent mission-aligned after just two years of our mission-alignment decision. As of our last review, we were exceeding our performance benchmarks by 200 bps, despite — or I like to think, because of — the movement into impact investments.”
In addition to performing well over the past several years, impact investments have proven resilient during market downturns. For example, in the first quarter of 2020, when the world was falling apart, companies that are strongly aligned with ESG principles withstood the drop better than the general market did. Yes, their prices fell significantly, but not as much as other funds, in general. (See chart, “Percent change in total return of funds Q1/2020”.)
“The relative outperformance of ESG funds makes sense when you think about the types of companies they invest in,” says Harrison. “ESG and impact investing favors high-quality businesses with long-term, resilient competitive advantages, and typically excludes highly carbon intensive businesses such as energy and mining – industries that have been hit hard in this recent downturn.”
Impact investments are typically long-term investments, which adds to their price stability in volatile markets. Those that choose investments based on ESG or SRI criteria are often looking to pass more than money down to their heirs.
“There’s another element to this approach that’s equally important. A values-aligned investment strategy tends to bring a family closer together,” says Harrison. “It becomes about more than the money — it is a legacy of values that is passed down and unites a family rather than divides it.”
AFFORDABLE HOUSING
In the real assets sector, one of the most accessible impact investments is low-cost housing, also known as workforce, attainable or inclusive housing. These are assets typically targeted to families and individuals making between 60 percent and 120 percent of the local median income. Rents are set to reflect the lower income. For example, the developer might target families making less than 80 percent of the local median income and set the rents to take up no more than 30 percent of their income. Developers are able to provide housing at below-market rates because they either use below-market financing, often provided through government-backed tax credits or bonds, or they use cost-efficient processes to acquire land and construct the project at below-market costs. They also can underwrite returns at 100 percent occupancy because these assets almost always have waiting lists, so there are rarely empty units.
Returns on these investments generally depend on what part of the lower-income spectrum is targeted. While some assets targeting middle-class workers, such as policemen, firemen, teachers, nurses, young professionals, etc., might see returns in the core real estate range, those targeting low-income or Section 8 renters might be looking more in the 2 percent or 3 percent IRR range. So, do investors give up return by investing in low-income housing?
“Not really,” says Warren Hanson, founder, president and CEO of the Greater Minnesota Housing Fund and Minnesota Equity Fund. “If investors were investing in 10-year Treasuries today, they would get less than 1 percent. You can receive more than that, with a similar risk/return profile, when you invest in opportunities that provide direct help to local communities and families in need of affordable housing. However, if you compare our returns to the S&P, which rose 30 percent in 2019, or Apple stock values that increased 89 percent, one would give up substantial returns in the monetary sense. But we measure returns in an economic plus social plus environment triple bottom line. We save lives while providing economic benefits to the investor, not to mention indirect economic benefits to the community.”
When compared with the appropriate benchmark, which is often a fixed-income index as opposed to a real estate index, affordable, workforce and attainable housing can hold its own. Investors are not going to realize value-added returns, but they can see returns significantly better than they are getting in their fixed-income portfolio, while taking on very little risk.
“Affordable housing has proven to be a secure investment,” says Hanson. “There is unlimited demand for housing that is more affordable, the waiting lists are long, and it performed better than any other real estate sector during the 2008 recession, which might be prologue to our current economic situation.”
In addition to providing a positive impact on people’s lives, as well as being a secure investment, attainable housing has a positive effect on the environment.
“People in the lower- and moderate-income range often have to live quite far from their jobs because they can’t afford to live in the city,” says Ken Valach, CEO of Trammell Crow Residential and Crow Holdings Industrial. “That results in long commutes, more traffic, more pollution, more gasoline, more CO2 — just more of everything we are trying to reduce. Building attainable housing can reduce the amount of time these workers spend on the road, reduce the pollution and give them more time with their families.”
THE UPSHOT
“Impact investing is and will continue to be transformative,” asserts Sorenson.
We are still in the infant or possibly toddler stage, however. There are still wrinkles that need to be ironed out. For example, we don’t yet have an agreed-upon index or metric that measures the amount of impact an investment is making. Knowing for sure that their money is making the kind of impact they expect will go a long way to making more investors comfortable with the strategy. And, as much as it is talked about, it is not yet the mainstream way to construct a portfolio.
“We are still in an opt-in framework, where investors have to seek out impact investments,” says Harrison. “But we will eventually evolve to an opt-out framework, where the standard investment will be ESG, and those that want something else will have to proactively look elsewhere.”
When that happens, impact investing will take its seat at the head of the table.
Sheila Hopkins is a freelance writer living in Auburn, Ala.