How do you measure the social impact of an equity portfolio?

Impact investing, or investing for social impact, is one of the most interesting developments in the investment marketplace over the last few years.  This generally refers to illiquid securities that aren't traded on a recognised exchange and isn't the subject of this post, but one aspect of impact investing is very pertinent for listed investment portfolios - the measurement of social impact.  As impact investments are chiefly concerned with social impact, a lot of work has been done on demonstrating and measuring social impact.  In particular, the Global Impact and Investing Network launched the Impact Reporting and Investment Standards, a set of metrics to measure an organisation's social, environmental and financial impacts.

" We've not been very good at analysing social impact as an industry and could do a lot better"

Notwithstanding the difficulties of this for a highly diversified listed portfolio, I think we've not been very good at analysing social impact as an industry and could do a lot better.  Best practice currently consists of describing what a few selected companies do and the social merit of that.  Valuable as this is, it hardly paints an accurate picture and is woefully incomplete.  Detailing the social and environmental impact of one company is one thing, doing it for 100 or more companies is quite another.  Creating a mountain of data would not only be extremely time consuming but ultimately, might not be very useful.

Too much data would only confuse investors

My initial solution is to classify each holding according to its ethical function.  This enables investors to understand what role each investment plays in terms of social impact, and the make up of collective funds in terms of ethical characteristics.  Its a somewhat crude mechanism but I think it gives a fair picture overall.  There's an element of subjectivity in classifying what constitutes best practice or what is a social solution, but nevertheless, it does bring some objectivity and transparency.  In practice, I've gone through every single holding of over 100 socially responsible investment funds and categorised them according to the following methodology:

Little Ethical Merit
Core activity confers no clear social or environmental benefits.  This is self explanatory - stocks which might meet negative avoidance criteria, but which seem to offer little in contributing to a better world.

Solutions Based
Core products and services are of direct social or environmental benefit.  These include clean energy, resource efficiency, clean air and water, healthcare, education, public transport, safety, sustainable food and agriculture, social housing and inclusive finance. 

Best of Sector
Social and/or environmental practices are amongst the best in its sector.  Necessarily, there is some subjectivity as to what constitutes best practice in a sector, but both secondary and primary research is used to assess relative performance.

Game Changer
Game Changers are companies whose shares are easily trade-able and that are key players in moving to a more sustainable world.  They may have elements which are ethically controversial but they constitute major companies with a large capitalisation that have a clear sustainability vision and can demonstrate that they are implementing this.

Having categorised each holding, the ethical distribution can be made clear, following the same sort of analysis and discipline that typifies financial analysis.

 Ethical classification of holdings enables a simple for of social impact reporting

This makes comparison of the content of ethical funds that much more objective and based on evidence rather than ad hoc examples and ethical criteria.  It also gives a much better overall flavour of the fund.  I'll look to develop this over time, but I've found it to be a very useful tool for both analysing funds and for reporting to investors.

Investing with Integrity

In my last post I alluded to my concerns about the socially responsible investment (SRI) market.  I've always believed in putting my money where my mouth is, so I've experimented in developing my own portfolio over a period of several years and without going through the highs and lows of this, I've settled on an approach that I think has wider application.  I've called this approach '3D Investing' and it aims to maintain the ethical integrity of an investment portfolio by minimising ethical compromise, maximising social impact and meeting financial expectations.  My belief (based on 20 years experience of advising socially motivated investors) is that many investors, and especially those that have inherited large sums or who have been successful entrepreneurs, really do want to do more with their money than just make some more, albeit in a more 'ethical' manner.  They often want to be involved with their investments, seeing the difference they can make beyond financial return, and if they can see the social impact, may be prepared to take on a higher level of risk.

 "Many investors, and especially those that have inherited large sums or who have been successful entrepreneurs, really do want to do more with their money than just make some more"

I share these beliefs which are all based on maintaining a high degree of ethical integrity.  All fine words, but what does this mean and how can anyone else know whether it might resonate with them?  I'm therefore setting out the principles that underpin the 3D Investing approach.  Some of these might seem obvious, but the simple fact is that these are rarely followed in entirety and I don't know of any existing portfolio management service that embraces this philosophy.  So, I think it worth  documenting what I believe to be the core foundations of investing with integrity for socially motivated investors:


Inspiring investments
3D investments need to inspire the investor.  It’s no good just replicating an index.  3D investments need to be compelling.

Investing in the welfare of people can be really inspiring

Be transparent 
Transparency is at the heart of 3D investing.  If compromises have to be made (and they usually do), then you need to be confident that all of the pros and cons have been considered, and to be able to see the evidence.


Social impact is a core purpose  
It’s not enough to simply avoid the 'bads' (negative screening), choose the 'least worsts' (best of class) or to put a small amount of the portfolio in positively screened stocks (thematic investment).  Within the given financial parameters, the goal is to maximise social return wherever possible.
 

3D Investing is not philanthropy but rather, an investment approach

Financial returns should reflect the level of risk being taken   
It is not a philanthropic exercise, but rather a way of generating long-term financial returns commensurate with the investor’s attitude to risk. 


Minimise ethical compromise 
Some ethical compromise is inevitable but this should be readily defensible and reduced wherever possible. 


Take good risks 
Taking risk is part and parcel of 3D investing, but risks need to be quantifiable, known and reduced by utilising a wide variety of assets and by appropriate use of collective vehicles.   

Risks need to be quantifiable, known and reduced

Investments are not short-term trades
3D investing is all about investing in financially sustainable investments in the long-term.  This means low levels of turnover, which also means lower transaction charges. 

This is very different to most socially responsible investment portfolios and I'll explain why in my next post.

What's different about 3D Investing?

I previously outlined the philosophy behind the investment approach that I've dubbed '3D Investing', and in a continuation of an exploration of the thinking behind this approach, I'd like to explain why I think its distinctive and why I think its worth developing.

The ubiquitous wind turbine image can mislead

Its my experience that ethical or socially responsible investment portfolios often sound great in theory, and are promoted with pictures of wind turbines and the assurance that someone is looking after your money so you can sleep easily at night, but the reality is sometimes disappointing.   I believe that 3D investing is very different to this for a number of reasons.

 

Impact Measurement

The proportion of ethical funds investing in social or environmental solutions is often low, so your money isn’t actually doing that much good. 3D investing requires measurement of how much of each fund is invested in companies providing social solutions, and what ethical impact each stock has. It is then possible to identify those funds with a relatively high social impact, enabling investors to make a difference with their money. 

Highlighting Concerns

Typically, ethical funds profile companies with positive attributes but say little about more controversial holdings.  3D investing actively seeks to identify any potential areas of concern so that investors are aware of any social compromises and can make informed judgements as to social suitability.

 "3D Investing identifies areas of concern so that investors are aware of any ethical compromises, whilst also assessing how well a fund is addressing the inevitable ethical conundrums"

Maximising Financial Returns is not the Goal
Ethical investment is often reduced to maximising investment returns from a pre-described universe of ethically screened stocks or funds. Despite having an ethical badge, this does little to make a social impact. 3D investing does not seek to chase financial returns at the cost of watering down the social impact, nor is it a philanthropic gesture. Rather, it seeks to deliver on financial expectations by investing in a broad portfolio of well managed funds, all of which have a social purpose.


Investment not Trading
The average holding period of equities is measured in months rather than years. This makes ‘investing’ more like a trade than a true investment. There is no social value to this. 3D investing therefore holds investments on a long-term basis and does not seek to change them unless there is a fundamental change in outlook or the needs of the investor.

"Much 'investment' is trading with little social benefit" 

Wider Choice of Assets
Portfolio managers virtually all claim to spread risk by appropriate asset diversification, but this often comes down to a simple split between bonds and equities, with little or no allocation to alternatives. 3D investing offers a much wider choice of assets including microfinance, social property and infrastructure. As part of a diversified portfolio, these contribute to reducing overall risk.


Inspiring Investments
Investment is commonly reduced to facts and figures. Indeed some investment analysis discusses numbers without even stating what the company does! 3D investing seeks to inspire investors, to get investors excited about their money and what it can achieve.  Existing ethical investment providers try to do this too, but in all too many cases its a piecemeal approach whereby only a select few stocks are picked out, conveniently failing to justify the rest.

For me, inspiring investors across the spectrum of different types of investment and backing this up with clear evidence, is the essence of what I'm talking about.  Can I, with hand on heart, know that each and every one of my investments has a social value, and can I say what that is?  I hope I can demonstrate that this is indeed the case.

What's wrong with socially responsible investment?

Welcome to 'Make Money Work'.  I've been involved in ethical investment (yes I still like to call it that, despite the somewhat Presbyterian overtones) for over 24 years, firstly as an adviser and latterly as a researcher and developer of portfolio management services.  I'm a passionate believer in the power of money to do 'good' and in socially responsible investment (SRI) as a tool to help make the world a better place. 

Over the last 24 years I've seen the blossoming of what was a very small sector of the market to something far more significant and there's no doubting the good things it has achieved - raising corporate standards, financing new environmental technologies and providing a choice for socially motivated investors - but I have serious concerns about the socially responsible investment industry as a whole.  Here's why:



Lack of Transparency
Transparency is at the very heart of ethical investment.  Typically, ethical funds only list their top ten holdings as a matter of course and simple naming of companies won't mean very much to the average investor.  Furthermore, funds tend to profile companies with positive attributes but say little about more controversial holdings.  This isn't good enough.  Socially motivated investors would benefit from an ethical rationale for each and every holding, not just a select few.  Claims of the need for commercial confidentiality just don't stack up - a select few funds do this, so why not the rest?  And where potential areas of concern exist, investors need to be made aware of them so that they can make informed judgements as to social suitability.

" Why can't all companies tell us something about each and every company in which they are invested?"

Lack of Impact
Ethical or socially responsible investment is often reduced to maximising investment returns from a prescribed universe of ethically screened stocks or funds.  Despite having an ethical badge, this usually does little to make a social impact, since the proportion of the fund held in companies that make a clear social impact is usually low.  The stated positive criteria in non-thematic funds are little more than aspirational ideals, but having positive criteria makes it look as though the fund is actively invested in a positive manner when, in reality, only a very small percentage is invested in that way.  Stating the actual percentages invested in social and environmental solutions and describing each and every holding would go a long way to making the social impact clear and to highlighting those funds that actually make a social impact.  

"The average ethical fund invests less than 25% of the fund in companies whose core products or services are of direct social or environmental benefit"

Short-termism 

Trading adds little social value

The average holding period of equities is measured in months rather than years.  This makes ‘investing’ more like a trade than a true investment.  There is no social value to this.   Clearly, there is a need to change investments if the fundamental view on a stock has changed, but portfolios with high turnovers are indicative of trading which is purely dictated by financial considerations.  Many ethical portfolios seem little different from their conventional counterparts in this respect and this sits uneasily with the concept of investing to make a social difference.


Ethical Compromise
Despite having clearly defined ethical criteria, many, if not most ethical funds, seem to make major compromises that, if investors were aware of them, would very likely cause concern.  This demonstrates the problem of comparing funds based on criteria rather than content, which allows stocks that fit the criteria to be included even though they raise significant ethical issues.  Furthermore, sustainability funds justify selection based on their consideration of a company's sustainability profile.  Some of their conclusions are surprising to say the least.  How does Monsanto justify inclusion in a sustainable portfolio when it has run roughshod over farmers, citizens and countries, to the extent that online campaigning group is presenting the company with a prize for being 'the most evil company in the world'.  

How can 'the most evil company in the world' be a sustainable investment?

 Or how does Amazon get to be in a leading ethical fund when aggressive tax avoidance is a key part of its business model, and it stands accused of very poor employment practice?  I believe that investments like these undermine ethical investment and have no place in it.  If investors are to trust their investment manager, they need to be confident in the process and this means absolute transparency and a clear determination to minimise the ethical compromises being made.

After 24 years of researching and advising on ethical investments I have come to the conclusion that the existing portfolio management services are largely failing socially motivated investors who want to make a social difference with their money.  As a result I am attempting to help advisors and managers to develop and run services that better meet the aspirations and needs of these investors.  I'm calling it 3D Investing and I'll talk about it in my next blog entry.