If you have tuned into the financial or mainstream news lately, you’ve likely come across the heated debate over the merits of ESG (Environmental, Social & Governance) investing. When we talk about ESG – we’re focusing on investing in mostly public-market funds that incorporate material, non-financial ESG data, screens, and risk factors into security selection and portfolio construction processes.

There have been many recent spotlights critiquing ESG investing calling it everything from “a broken system,”[1] to a “loser.”[2] Much of the criticism levied at ESG funds points to the idea that ESG products generally invest in similar companies and securities as non-ESG products and generate little impact or positive societal change. Yet this critique paints every ESG fund with the same broad brush – and doesn’t take into consideration the nuanced differences available across investment strategies incorporating ESG.

ESG is not a standalone investment strategy, but rather an input into a broader investment approach designed to either mitigate risk or generate returns by under- or over-weighting companies based on various factors. Therefore, ESG factors can be utilized by both traditional funds as well as ESG-labeled products. Take Blackrock, for example, who announced in 2018 that all the firm’s strategies, whether ESG labeled or not, would integrate ESG risk factors as part of their investment process. Similarly, Fidelity has adopted a firm wide ESG policy and made ESG risk factors available to all portfolio managers at the company. These managers do not pretend that integrating ESG data makes every one of their funds an “ESG fund”, they are taking the approach that ESG factors are part of a broader set of material financial and non-financial factors that should be incorporated into the investment process.

What are “ESG Funds”?

ESG-labeled funds, on the contrary, make ESG data and risk factors central to their portfolio construction framework. How ESG funds integrate this data can vary. Some passive funds track indices that use ESG data to create a scoring system for security inclusion, while other funds, both passive and active, use novel approaches to ESG data integration or fundamental ESG analysis to create an investable universe and select investments. Many ESG funds overlay this data integration with exclusionary frameworks that restrict investment in certain “sin” sectors to create specific value-alignment.

If value-alignment and supporting companies with strong backward-looking ESG data is your core objective, then ESG funds have the potential to meet your goals. However, if outcome-oriented impact is what you strive for, then most ESG funds have the potential to fall short of your goals.

Moving from ESG into Impact Investments

There appears to be an industry consensus that impact investments are “investments made with the intention to generate positive, measurable social and environmental impact alongside a financial return.”[3] By this definition, impact requires intentionality of a strategy with clear measurement of progress against its goals. While public funds can meet this definition of an impact investment, it is our opinion that many ESG-labeled products in the market today fall short.

Public ESG funds sit on a spectrum regarding the amount of measurable impact they have on the world.  Some funds utilize strategies that can lead to a higher potential for impact – particularly as it relates to influencing company practices – while others provide value-alignment through a “do no harm” approach. Public impact investment funds are fundamentally different than ESG funds in that they direct capital to organizations working to solve global problems or seek to achieve specific impact outcomes.

Using our database, we have analyzed over 300 public funds that we believe have especially strong ESG or impact practices. We have identified four strategies through which public funds can demonstrate deeper authenticity of their approach and seek to rise to the standard of an impact investment. Let’s discuss a few. The first two strategies enhance the depth of the ESG framework, while the second two increase the likelihood of impact outcomes.

1) Novel and authentic approach to ESG data integration

Today, any asset manager can use an ESG data provider to rank companies and build a portfolio based on a rules-based selection process. Some of the best ESG funds take a novel approach to ESG data integration by using a variety of sources of raw external data to create their own proprietary datasets while analyzing ESG factors with the same rigor as financial factors. Generally, funds that authentically integrate ESG data into their portfolio construction process will end up with a product that is materially different than their benchmark non-ESG fund.

One example of this is a global, factor-based fund with a stated goal of advancing women in business and promoting gender equality in the workplace. In pursuit of this goal, the fund manager has developed a proprietary dataset and subsequent index that ranks companies based on several women-focused ESG factors including representation of women on boards of directors; representation of women in executive management; hiring, promotion, and retention of women; gender pay equity; proactive gender goals and targets; and transparency about gender diversity data. This product  puts specific ESG data at the forefront of its investment selection process, analyzes it in a unique way, and has created a differentiated global equity portfolio.

When considering the depth of an ESG fund’s data integration and analysis, consider the following questions:

  • i. Where is the ESG data coming from?
  • ii. How is data being analyzed to inform portfolio construction?
  • iii. After the data is integrated, how different are the underlying holdings of this portfolio compared to the benchmark or a non-ESG counterpart?
  • iv. Does the fund show concentrated portfolio exposures to best-in-class ESG companies? Or is the fund more broadly diversified?

2) Shareholder advocacy and active engagement with portfolio companies

Beyond portfolio construction, one of the clearest ways that a fund manager can have a cause-and-effect relationship around social and environmental outcomes is to engage directly with companies to hold them accountable to ESG objectives and values. To do this, funds who employ this strategy should rigorously evaluate and vote proxies in a way that is consistent with their outcome goals, engage with upper-level management at portfolio companies to influence decision making, and, if needed, propose shareholder resolutions and in some cases run activist campaigns to try to align company practices with ESG goals.

There are a subset of sustainable asset managers who use active engagement as a cornerstone of their product offering. For example, across their funds, one leading manager uses dedicated engagement resources to work with portfolio companies on furthering social and environmental goals and alignment. Additionally, this manager provides unique transparency around their proxy voting practices which allows investors to see how the firm is aligning its actions as an active shareholder with its stated sustainability and ESG mandates.

Advocacy and engagement are effective tools in public markets to further ESG goals and have the potential to drive intentional impact internally at companies. However, advocacy and engagement must be rigorously evaluated to determine their authenticity. Consider asking the following questions when looking at a product that cites advocacy and engagement as central to its story:

  • i. How targeted, consistent, and transparent is the fund’s proxy voting and engagement policy?
  • ii. Does the fund tie engagement practices to overall ESG goals?
  • iii. Does the fund measure and report on the outcomes of its advocacy and engagement initiatives?
  • iv. Has the fund manager taken a leadership role in proposing shareholder resolutions or managing an activist campaign?

3) Investment in “solutions” oriented companies

A growing set of public funds invest in companies that generate a material percentage of their revenues from products and services aimed at tackling issues aligned with the UN Sustainable Development Goals (“SDGs”), such as climate mitigation, economic mobility, financial inclusion, affordable housing, and access to educational opportunities. Many of these solutions-oriented funds focus on a single impact theme, especially around environmental sectors.

One example of this type of solution-oriented strategy is a manager who focuses on investments in sustainable infrastructure and natural resources equity strategies. These strategies focus on investing in organizations addressing the global scarcity of clean and safe water, clean energy, and food; investing in companies helping to solve some of the world’s most pressing issues as they relate to scarcity of resources. These funds typically are highly differentiated and biased toward smaller cap companies that have less exposure to mainstream index funds. Companies owned by these funds are often investing in scaling products and services that include solar and wind technologies, water desalination solutions, and regenerative agricultural services.

It’s worth noting that these funds tend to be more concentrated given the specificity of their strategy, which can often mean higher volatility given their emphasis on sector-specific or concentrated portfolio construction. Additionally, there are often challenges with assessing the percentage of fund investment revenue tied to specific SDGs because companies don’t normally report revenues in a manner consistent with SDG alignment. When evaluating the impact potential of these strategies, consider asking:

  • i. What is the fund’s process for evaluating revenue alignment with SDGs and what are the data sources used to do so?
  • ii. How dedicated is the asset manager to investing with SDG alignment across all of their strategies vs. one specific fund?
  • iii. What is the additionality tied to the fund’s investment in target companies in relation to the development or scale of company products and services?

4) Investment, measurement, and reporting tied to specific and clear outcomes

Finally, some funds have gone beyond investing in solutions-oriented companies to investing in securities tied to specific forward-looking outcomes. This is a relatively hard strategy to implement in secondary public markets. However, certain fixed income funds now invest in debt earmarked for projects and services related to an SDG theme or targeted population, which can lead to higher additionality and impact.

One example comes from an asset manager that invests in bonds issued by companies and governments that use the proceeds of capital raises for specific impact initiatives. This allows the firm to direct capital in a way that many other investors in listed securities cannot, and subsequently allows them to evaluate and track outcomes more closely. Today, this manager is able to use investments in fixed income securities to create customized place-based portfolios that target specific impact geographies including regions, states, and counties, as well as target specific impact themes or initiatives. When reviewing a strategy like this one, consider asking these questions when dissecting the fund’s potential for impact:

  • i. Is the fund making purchases of new issuances or buying bonds or securities on the secondary market?
  • ii. Is the strategy intentional in the impact themes it targets, or is it simply aggregating whatever impact themes its investees happen to report?
  • iii. Does the fund measure and report on the outcomes and additionality of its capital at a granular level?

Public fund impact measurement and management is still nascent and will continue to improve

The examples highlighted above are still the exception rather than the rule. Recent research from the Global Impact Investing Network (GIIN) states that “maximizing impact in listed equities requires a re-focusing of the entire investment process in order to arrive at a materially different portfolio than a standard ESG fund.”[4] While public funds can meet this bar for impact, the GIIN’s research went further to note that a critical piece of designing an impact investment product in public markets is the measurement of impact outcomes for investors. The strategies highlighted above give public funds a toolkit to generate impact, but measurement of outcome success remains difficult. Due to the difficulty in quantifying the additionality of investor capital as it relates to impact in liquid securities, measurements of impact outcomes are often ad-hoc, unsystematic, and highly qualitative.

However, we expect public markets to continue to evolve the standards by which asset managers are held accountable in describing both their ESG frameworks and, importantly, impact targets and assessment of outcomes.

Our hope is that more public managers will consider making the leap from basic ESG practices into forward-looking impact strategies that drive and report on measurable environmental, social, and governance outcomes.

Most impact-oriented investors continue to hold the majority of their assets in public markets. While always considering one’s risk, return, and liquidity objectives, investors have a key role to play in helping the industry move forward by continuing to ask informed questions, request more robust metrics, and support public managers on this journey.