Successfully executing an impact investment portfolio involves thoughtful asset allocation and thorough due diligence. Carefully defining these factors can promote outcomes well-aligned with investor goals.
Before diving into asset allocation and execution strategies, here is a brief overview of the different asset classes an impact investor can explore. Remember, each investor’s portfolio and distribution and inclusion of the various asset classes will look different according to their desires.
- Cash and Cash Alternatives
- Notes, Other Debt Obligations, Bonds, Absolute Return and Low Equity-Correlated Strategies
- Public Equity, Equity Long/Short and Private Equity
- Real Estate/ Real Assets
“Asset allocation” refers to the method by which an investor spreads out risk across different asset categories. As mentioned in “How to Build an Impact Investment Portfolio”, each investor’s overall vision for the time horizon and impact goals of their portfolio (outlined in the IPS) will help dictate the direction of a portfolio’s asset allocation.
Asset Allocation can be done across asset classes as there is no one “right” method. Asset classes carry different levels of risk and return, as well as liquidity levels. Evaluating asset allocation also helps an investor decide whether the impact is redundant, complementary, or catalytic.
There are a few key aspects to consider when evaluating the possibilities, including a company or fund’s history, current events, and other externalities which affect impact industries over time. These can vary from economic volatility, government intervention, and economic position on entry.
Liquidity is also an important factor to consider at this stage: while the markets for so-called “clean stocks” remain relatively niche, wider interest is growing with increased exposure. As any seasoned investor is aware, market conditions fluctuate regularly—the importance of revisiting and revising one’s portfolio over time cannot be understated.
Measuring Risk via Standard Deviation
Standard deviation represents how much an investment’s price varies from the mean return over time. The higher the standard deviation, the higher the risk. As in any other investment, the higher the risk, the higher the reward (and higher the losses). This value is usually represented as a number or rating in a report, and in the universe of impact investing, diversifying across volatile deviation and mild deviation will help more accurately assess risk.
Role of Correlation
Correlation refers to the strength and direction of a linear relationship between price movements of two asset classes over time.
Traditional investors most often look to break correlation between asset classes to further spread risk. Impact investments often share less of a correlative relationship to their surrounding industries, making them both socially and financially beneficial in execution.
Executing Allocation Plan
Once an investor’s impact portfolio theme and asset allocations are collected, it is time to put the portfolio into action. There are two main avenues for doing so: direct investments and/or existing funds. This decision is critical as it will determine the level to which the investor will have to actively measure their impact and fulfill due diligence.
The figure below, courtesy of Philanthropy Impact, provides an example of the cross section between Impact Themes and Asset Class exposure
By investing in an existing fund (such as the Vital Capital Fund or Humankind), it is easier to track and measure the degree of impact. However, doing so compromises the autonomy of the investor themselves. They have the option to directly invest in an industry or even create their own funds.
In the past few years, resources and networks have grown exponentially which connect impact investors to funds and impact missions around the globe. One of the most prominent examples is the Global Impact Investing Network (GIIN), whose members have access to strategic alliances with other impact investors as well as educational services and industry research. These networks provide a reservoir of resources, strategies and experience for new and seasoned investors alike.
An impact investor’s goals of achieving both financial and social benefits create great need for thorough due diligence. Due diligence helps an investor track progress towards financial and social impact quotas. This latter aspect is challenging, as there is not yet a standardized form of social impact measurement. However, as the field grows so will the means to measure the success of these programs.
Starting with another series of reflection questions can guide the process:
- How does the industry you are hoping to impact define “success”? What led to these definitions?
- Who are the current players in the industry (companies? Investment managers?)
- What is the interplay between the public and private sector investment outcomes?
- What strategies have similarly aligned impact investors used in the past?
- It can also be helpful to gauge exit and entry points: Is this a shorter term investment? Long term?
Although there is no “right” way to approach due diligence, asking the right questions is critical in fulfilling the task.
For impact investors, using a rating system for each issue area has become a common approach to analyze impact. On a scale from 0 to 4, investors can categorize between No Impact to High Impact.
Calculating Social Return
There are a few ways to approach calculating social return depending on the portfolio. However, the generally used formula involves two steps: the issue area exposure values (value of long positions minus the value of short positions) is multiplied by the impact ratings. Those raw impact scores (which indicate the level of impact per invested dollar) are then multiplied by the investor’s set of issue area concentration preferences. The final number represents the expected social return.
The social impact can also be calculated using earnings via the following formula:
The development of quantitative analysis tools are ongoing, and depending on the asset category there may be more fitting means of measurement. In this environment, collaboration and strategy exchange between impact investors is critical to building tools and identifying the best course of action.
The post-pandemic economy provides an impact investing landscape with low barriers to entry and high potential for tangible, measurable change. With thorough planning and execution, impact investing represents an innovative way to change the world for the better.