Impact Orientation in ESG Investing

Socially responsible, or ESG (Environmental, Social, Governance) investing, means different things to different people. This is also true for professional investors. There is currently much debate and disorganization around how we should talk about and execute investing in a socially responsible way. Given that it historically has largely been a subjective topic guided by disintegrated data, it has been difficult to create any type of authority around the process. However, the Longwave ESG essay series is an attempt to define concepts and philosophies, the first step towards creating a reliable framework and best practices.

We started with the simple question: “What is ESG investing?”. Now we’re going to dive into impact investing and understand how it is differentiated from other types of ESG-based capital allocation, such as underweight/overweight and exclusionary investing. Impact investing, characterized by its impact orientation, is the most granular, active, and arguably meaningful way of ESG capital placement from a tracking perspective. It also takes the most resources, skill, and dedication to execute.

What is Impact Investing? A Closer Look

Impact investing is defined as a method of active capital allocation that focuses on tangible, direct, and quantifiable environmental, community, or governance-based results that also provides a competitive risk-adjusted return. Other organizations may define it differently, but we believe it is important to make a distinction between passive, underweight/overweight, exclusionary, and impact-based ESG investing which organizations seem to conflate together. Many in the space seem to call everything that has the slightest hint of an ESG framework “impact” investing, which makes the term largely meaningless marketing jargon. Longwave’s decades-long experience in the space sees a need to define this so you know what you are getting when you invest with us.      

Digging into the concept, you can see that impact investing is the next level above a passive ESG benchmark fund or even an active “exclusionary” ESG fund that eliminates bad actors and focuses on future innovations to make the world a greener, better place. These approaches are necessary due to their widely accessible nature, being offered in mutual funds and ETF forms with very low minimum investment amounts and fees. Anyone with as little as $10 can participate in investing in a socially responsible way through these vehicles, they are the first step into ESG investing.

However, it is important to note that when it comes to equity investing, we are participating in the secondary market. What this means is that when we buy a stock, we are purchasing a certificate of ownership in a company that has already been issued, and the capital has already been raised for that company in an IPO (initial public offering). Therefore, the measurable impact of buying or not buying that company’s shares is questionable at best, especially in the age of extremely efficient markets, hedgers, and trading machines. Prices tend to stabilize to fair value whether you ignore that company’s shares or not, that is the essence of an efficient market. A primary argument for divestment in a company’s stock is that if the pressure is great enough it could potentially hurt that stock’s performance and put pressure on management whose pay is largely tied to that stock’s performance. This theory is difficult to quantify and relies on a large enough divestment to move prices away from fair value of cash flows or present value of growth opportunities, no small feat when most investors are motivated by returns first.

When it comes to fixed income (bonds) it is easier to see a connection between divestment and quantifiable results. Bond funds such as mutual funds and ETFs still largely participate in the secondary market (already issued securities) but a lack of demand for lending instruments in particular segments has an impact on borrowing costs. This makes projects that investors don’t want to invest in more expensive to execute because the cost of borrowing is higher. Institutions with large amounts of investible capital can dictate the profitability of business projects by either supporting or not supporting the capital lending toward those projects.

This brings us back to the distinction of impact investing. It attempts to fix concerns around measurable results in capital placement. Impact investing can look like activist investing, which is a tactic of buying a significant ownership stake in a company to have enough voting power to influence or change management towards better governance around ESG factors. There are funds that do this but are largely in private markets with very high minimum capital requirements, often in the millions. This is because it requires hundreds of millions of dollars to buy enough of a company to have influence, even in small companies which generally have more concentrated ownership. The threshold before you get representation on a company’s board is generally 10%, but you must register as an activist investor once you amass 5% of the company’s shares. You can see that for a company with a value of 250 million – 2 billion (small cap stocks) this could get prohibitively expensive, especially when you need to own 30+ companies to make a diversified fund. Other tactics could look like direct lending to ESG opportunities, venture capital, leveraged buyouts, long-short, and municipal lending. All these ways of investing have direct capital placement where your dollars are easily traceable and can be quantified for their impact.

 Who is Eligible to Engage?

If you have any experience with the methods of investing mentioned, you can see impact orientation tactics are mostly reserved for the wealthiest among us. There are some exceptions, with a handful of impact-oriented funds Longwave has identified that take one or more of these strategies to the masses, but they are generally more expensive and require high due diligence by a financial professional. At Longwave, we have scoured the ESG marketplace for the most authentic funds in each of the core ESG strategies, of impact, underweight/overweight, and exclusionary that also meet competitive metrics around risk-adjusted returns and fees. We have built impact opportunities as we define them into our core portfolio strategies where we can have the most measurable results, small-cap, and fixed income, allowing us to roll out an impact orientation generally reserved for institutions to our clients.

 Connect with Longwave Financial

At Longwave we believe that if we are going to invest in a values-based way we need to be authentic and transparent in what we are offering. We build portfolios with sound and reliable data and couldn’t justify dealing with subjective or unquantifiable ESG metrics with questionable marketing statements. Therefore, we are not only building our portfolios with an impact orientation where we can but also engaging the marketplace with our power in capital to create more opportunities in impact investments for the masses. Our clients empower us to do this work and if you have questions about how to move from general ESG investing to impact investing, reach out to see what we are working on.