Three Sustainable Investing Strategies That Work
THE DEFINITIVE GUIDE TO SUSTAINABLE INVESTING - PART 7
This article is part of Bankeronwheels.com exclusive guide to Sustainable Investing.
Despite the expected Sustainable Investing underperformance, some investors may want to express their Sustainability views in their portfolios. How can you invest and impact the planet? Let’s look at how an investor can impact through three approaches, depending on your portfolio complexity.
KEY TAKEAWAYS
- There are at least three proven sustainable investing strategies.
- To keep it simple, you may hold a non-screened portfolio and, given the expected outperformance vs Sustainable Funds, use the incremental profits for philanthropy.
- If you want to avoid investing in certain types of industries, e.g. Tobacco companies, you may select cost-efficient and well-diversified SRI Funds.
- The most active sustainable strategy is Impact Investing. It is easier to implement for Institutional Investors through Private Equity or Private Debt markets.
- Individual investors can choose Thematic ETFs to address specific social or environmental issues.
Here is the full analysis
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- Don’t get fooled by Wall Street – Hardly anyone understands Sustainable Investing. ESG Ratings are not designed to protect the planet. Adjusted for risk, ESG ETFs will also inevitably underperform. But there are ways to invest Sustainably.
HOW CAN I HAVE AN IMPACT?
What are the most neutral positions?
Let’s take an individual Investor like Kumiko. She would like to avoid investing in Tobacco companies and ideally impact the planet positively. What are her options?
- Average market returns – are represented by the horizontal axis, e.g. Vanguard FTSE All-World ETF.
- Neutral Planet Impact – are represented by the vertical axis. If Kumiko’s position is on this axis, she won’t be invested in Tobacco but is not doing anything proactive for the planet either.
Your Personal Returns vs Impact Matrix
What Are the Four Quadrants?
- Low Planet Impact & High Returns – If Kumiko were here, she wouldn’t sleep well because this may represent, e.g. a diversified Sin Stock portfolio.
- Low Planet Impact & Low Returns – This quadrant is the worst. The Extreme case is a dart-throwing monkey, aka a sin stock-picker (negative impact and low returns).
- High Planet Impact & High Returns – Kumiko thought that Sustainable Investors were all in this quadrant before this guide showed her the truth.
- High Planet Impact & Low Returns – Kumiko now understands that impacting the planet positively means trade-offs and most investors end up somewhere in this quadrant. The Extreme case of this is charity (no returns).
Your Personal Returns vs Impact Matrix
So what can she realistically achieve? Let’s look at three strategies.
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Who Are Coaching Sessions For?
- Beginners often ask us: How do I reach my goals? When should I invest? How do I come up with the right asset allocation? What About Short-Term Investing?
- Advanced investors come to us to get their portfolios challenged: What could derail my strategy? Bond Ladder or Bond ETFs? What are risks related to Factor Premia? How much can I withdraw from my portfolio annually?
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THREE STRATEGIES
STRATEGY 1: Philanthropy (GOLDEN RETRIEVER STYLE)
How to implement?
A Golden Retriever-style solution involves two steps:
- Starting point: Kumiko will still hold a typical passive index portfolio (average market returns, some negative impact as also holding Tobacco companies).
- Actions: She will donate the difference in fees or outperformance. She will support charitable projects e.g. support local community or financing research to fight a disease.
This strategy moves her position from market returns & some negative planet impact to slightly below-average returns (as funding a charity) & positive planet impact.
Overall Financial & Planet Impact Profile of this strategy
Kumiko’s core portfolio remains passive. The downside of this solution is that she remains invested in some sin stocks.
If Kumiko were in the US, she may use certain ETFs, e.g. Engine No.1 S&P 500 ETF, to also align how the Fund votes with her values. With that respect, blockchain and direct voting can become even more interesting in the future.
Pro & Cons
- Simple and cost-efficient Portfolio
- Easy to implement
- Philanthropy Reflects your values
- You choose how much to give away
- ETFs may have investments misaligned with your values
STRATEGY 2: SRI EXCLUSIONS (CYCLIST STYLE)
How to implement?
A Cyclist-style solution involves:
- Starting point: Before taking any actions, the investor has a typical passive index portfolio.
- Actions: Replacing typical ETFs with SRI ETFs that exclude harmful companies (e.g. Tobacco). This involves marginal underperformance, but removes negative impact (net neutral – Kumiko won’t be financing the Tobacco Industry).
- Additional Step: Can add philanthropy projects to have a net positive impact.
The outcomes range from neutral impact and slightly below market returns (as SRI tends to underperform marginally) to positive impact when considering additional philanthropy.
Overall Financial & Planet Impact Profile of this strategy
This strategy requires reading our guide to keep ESG rating-related screening on portfolio companies low.
Pro & Cons
- Relatively Simple and efficient Portfolio
- Neutral Portfolio - Does no harm
- One stop solution
- May add Philanthropy For Positive Impact
- Involves more research
- May be a bit more expensive
- May have marginal impact on returns
Strategy 3: Impact Investing (BANKER STYLE)
How to implement?
A Banker-style solution involves:
Actions: Selecting active investments (Equity or Debt) like specialized healthcare or renewable energy projects that can transform the planet and society.
On average, these single investments will tend to underperform given idiosyncratic risks, but the range of outcomes is large. Impact investments must be considered in the context of the overall portfolio.
Overall Financial & Planet Impact Profile of this strategy
While the base case is that most of the start-ups underperform, there could be some substantial gains if you bet on the right technology. A Sustainable Venture Capital Fund is a good way of diversifying risks.
Pro & Cons
- Potential for truly transformative planet impact
- Reflects your beliefs
- Low Probability of high pay-off Investments
- Most Strategies are only Available to Institutional Investors
- Substantial risk of underperformance (Start-ups)
- Requires more extensive research (Active Investing)
IMPACT OF PASSIVE STRATEGIES
Before selecting your strategy, spend some time understanding the impact of passive strategies.
The Good - IT PenalizeS Sin Stocks
SRI Investing has some positive effects :
- More debate and voting against harmful projects – The most important one, in my eyes, is that there is more debate around the topic. Keeping sin companies in a portfolio, if one can cast votes like mentioned in the case of Strategy #1, can put pressure on management.
- Increasing financing costs of new projects for Sin companies – SRI investing (Strategy #2) puts pressure on management to avoid harmful project as they become more costly.
The Bad - Can't Stop THEm
Sin Companies may still go private, finding capital in Private Equity markets with less public scrutiny. That said, even if sin companies do go private, it comes at a higher capital cost for them.
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IMPACT OF ACTIVE STRATEGIES
What is Impact Investing?
Impact Investors invest in businesses that solve a particular environmental or social issue. For example, the impact investor might contribute capital to start a farm, rather than donating food.
The food from the farm would feed the local community. Any profits would be reinvested to expand the business, thus feeding more people, creating more jobs, and increasing the community’s resiliency. In some cases, for-profit investment models are more sustainable and can be more impactful than philanthropic ones.
What are the Types of Impact Investing?
Here are some ways of impact investing:
- Environment – Agriculture, Water, Energy or Forestry
- Minority and Women – Funds Firms run by minorities or women
- Poverty – funds firms in impoverished areas
- Social Infrastructure – e.g. microfinance, healthcare schools and housing
- SME Funding – in undercapitalized markets
- Focused Regional Development – job creation and development in a specific region
How Can I Find Investment Opportunities?
Unfortunately, Impact strategies can be difficult to invest in, as most are available only to institutions through Private Equity and Private Debt markets. Some options for individual investors include:
- Stocks – Thematic ETFs, including those focusing on 17 United Nations Sustainable Development Goals. But target specific niches (e.g. renewable energies or specialized healthcare) to complement your diversified portfolio, not SDG Index Funds that often include ESG Ratings. Be very critical about those.
- Bonds – Some ETFs may have a tilt towards Green Bonds that target, e.g. renewable energy projects. For Fixed Income, the EU Taxonomy is becoming the reference framework.
What Returns do Impact Investments Generate?
Similar to expected ESG and SRI underperformance, Impact Investing involves a cost.
A 2015 Impact Investing research paper covering 24,000 investments in over 4,500 Venture Capital and Growth Equity Funds concluded the following:
- After the full investment period, impact investments ended up generating a 4.7% lower return than traditional funds.
- For context, the starting point here are traditional Venture Capital Investments that tend to generate, on average, total returns over 20% but are characterized by very high dispersion as a significant part of investments tend to fail.
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CONCLUSION
Fortunately, there are still some ways to have a positive impact, but as we’ve seen, it is far from what investors typically believe. In the last article of the series, we will see how the Financial Industry is trying to clean up the mess it created over the past decade and whether there is any hope for better sustainable scores, and related ETFs, in the future.
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