Impact investments are on the rise, and many investors interested in jumping on board are unsure how to build a successful impact investment portfolio. This article will outline different strategies and procedures involved in building an impact investment portfolio, and provide resources to guide new and experienced investors alike.
Before diving in, it is important to note the difference between ESG investing and impact investing. While both operate under an investor with goals of social or environmental change, impact investors specifically target solutions to global challenges. ESG investments on the other hand are geared towards broad initiatives.
“Sleeve” vs “Lens Approach”
Impact investing most often takes one of two forms: either a “sleeve” or “lens” approach. A sleeve strategy groups impact investments within a larger portfolio of investments not specifically allocated towards ESG initiatives. It normally carves out a specific sector or asset class to denote a fraction of capital towards.
A “lens” approach takes the entire portfolio and targets impact related goals. These can still be across a broad spectrum, but each has a role to play in the impact goals of the investor. This is not just reductive (“what do we remove from the investment market to make impact”) but additive (“what can we add through investments to the sustainability market”).
A sleeve strategy may be favored in situations of stricter financial return targets or investment limitations, as it allows for leeway in more traditional markets. However, it should be noted that while impact investing carries risk as any other investment does, impact investments and ESG initiatives are trending in corporate investment strategies— in 2020 reporting strong return performance compared with non-ESG investments. In either case, adding impact investing can help minimize risk while maximizing opportunity.
Building an impact investment portfolio can be broken down into two steps: Defining Investor Goals and Objectives and Creating the Investment Policy Statement (IPS).
Step 1: Investor Goals and Objectives
The first step of creating any investment portfolio is to clearly define investor goals. Successful impact investing is no exception, and requires the investor have a vision for the kind of impact they hope to achieve. These goals will shift over time and are encouraged to be reviewed an annual basis (if not more frequently).
Along with defining impact goals, the investor will also define financial requirements like cash flow needs, risk tolerance, and projected time horizons much like in any other investment portfolio. By setting up clear parameters, an investor will receive a clearer picture of their returns and contribution to impacts annually.
After defining broad goals, the investor should define any “special circumstances”. These are unique to each investor. For an impact investment portfolio, values-alignment, impact preferences and impact investor type are all critical aspects to consider.
Different investors have distinct values driving their impact investing plan, and they may wish to screen out certain investment opportunities not aligned with these values. Investors can use exclusion criteria to screen out investments which do not align with their mission or financial targets. Defining areas of flexibility and inflexibility early in the portfolio building process helps set a strong foundation and will ultimately save time in the long run by consolidating choices.
Another category of special circumstances to consider are the impact preferences of the investor. These can be evaluated in a few ways, but a popular method is through creating a classification system of investor priority areas. Building an image of impact preference from broad issues (e.g. climate, social equity) to narrower reference fields (e.g. wind power, regional specificity) will help clarify success or failure of investing strategies. Athena Capital Advisors shares this example of a simplified classification system:
Impact Investor Type
As an investor, evaluating risk tolerance and return expectations can help when dealing with the natural tradeoffs between financial and impact goals. Models like the one below can help an investor figure out where they personally land on the spectrum. The IPS should include this category of investor preferences as well.
Step 2: Creating the Investment Policy Statement (IPS)
The Investment Policy Statement (IPS) synthesizes the financial requirements and special circumstances above into one unified format. In addition to the reflective information collected in Step 1, the IPS also takes shareholders’ concerns into account. For example, ESG related investments have historically been perceived as unpredictable in terms of risk and return. Should an investor follow this belief, listing this concern would be important.
To build the IPS, an investor should reflect on a few parameters. This can be broken down as “Invest for Better” recommends:
- Define Assets: What capital do you have to put towards portfolio? What are your financial requirements?
- Deployment of Assets: What asset class do you want to invest in?
- Liquidity Needs: Requirements? How long are you willing to wait for return on investment?
- Financial Risk, Return and Impact: Deeper dive into investor expectations—what are the return targets? Would you lower return expectations for the benefit for the environmental/social benefits? What are your areas of flexibility/inflexibility?
As described above, building an investment portfolio requires reflection and insight in a different manner than other portfolios. However, impact investment empowers the investor to directly influence the change they hope to see in the world while balancing financial needs. The next article will discuss the factors that go into executing an impact investment portfolio, as well as how to track social and environmental impact in data.