Part I: The Wealth Management evolution: Investing with purpose and impact

Impact investing is a concept we hear a lot about these days. It’s not only institutional and large private investors such as Family Offices who are looking for opportunities to invest their money “with purpose.”

In recent years, private investors as well have become more aware of investment goals beyond achieving a financial return. The younger generation of investors–– as well as women–– indicate that they want to make an “impact” with their money and invest in line with the values that are important to them. This desire goes beyond the sustainability investment theme that has been popular for some time. And it is not only about “purpose” and values but also about risk and long-term financial stability. Especially institutional investors have come to the conclusion that focusing on ESG (economic, social, governmental) criteria-oriented companies is less risky, as long-term results tend to be less volatile and deliver a superior risk-adjusted return.

This three-part series looks at recent market development and opportunities for non-professional investors, and how their expectations and needs can be met. We analyze the desire for impact investing compared with sustainable investing, with a focus on the “modern” Private Banking client; and consider how financial service providers can address these needs.

Part I takes a look at the market for impact investing and how it has developed.

SUSTAINABILITY – MORE THAN A TREND, BUT HOW DOES IT RELATE TO IMPACT?

Sustainable investing is nothing new. In fact, the first fund avoiding tobacco and alcohol companies, known as a negative screening approach, was launched in 1928. Today, almost all financial institutions offer a product suite based on ESG criteria. In 2018, more than USD 30 trillion had been sustainably invested with remarkable growth figures of 34% since 2016.

And there is far more potential: according to a Capgemini World Wealth Report 2022, 55% of HNWIs globally say investing in causes with Environmental, Social, and Governance (ESG) impact is a key objective when it comes to managing their wealth. Taking the market size calculated by the Boston Consulting group (BCG), global assets in 2019 were USD 226 trillion. Assuming a 75% share, market potential of around USD 170 trillion globally would result– or five times the current investment volume.

Putting these figures into perspective for Europe, where already 50% of assets are invested sustainably, the market potential comes to USD 7 trillion. Instead of continuing to grow, however, asset shares are stagnating. Considering that most of the sustainable investments (77%) are still invested using negative screening approaches, this may indicate that investors don’t find the sustainable investment solution they are looking for. The demand for ESG investments can be seen in the client awareness and the increasing importance of ESG investment objectives (Figure 1).

Figure 1. Geography and age affect HNWIs’ ESG investment objectives (Jan 2022)

This is where impact investing comes into the game. In these very particular areas, investment volume is still much smaller: only about USD 124 billion – less than 10% – is invested in impact in Europe. However, asset growth rates have been quite impressive: the compounded annual growth rate from 2016 to 2018 was 33.7% compared with an overall growth of 15.9% in the sustainability field, and with stagnating investment growth in Europe in general. The impressive growth of impact investing thus far can be attributed to institutional investors, due to the lack of investment opportunities for retail clients. But the interest of retail investors in this segment is set to expand. In the third part of this series, we’ll consider why impact investing opportunities for retail investors are still rather scarce and look at existing and potential solutions to meet these demands. But first we should define “impact,” to better understand what we mean by impact investing.

IMPACT VERSUS SUSTAINABILITY – CLARIFYING THE DIFFERENCE

At present, there are many terms like ESG, SRI (socially responsible investing), impact, or value-based used to describe the distinction between sustainability and impact, and they are not clearly differentiated.

This confusion is probably one reason why the full potential of impact investing has not yet been realized. The current market consensus seems to move toward two main categories: ESG and impact. While ESG criteria build the basis for sustainable investing, impact goes a step further: there must also be a quantitative angle. While in the traditional ESG approaches – especially negative screening – the “doing good” or “less bad” cannot be measured, impact investing always quantifies the ESG output (e.g., tons of carbon reduced). Further, impact is always based on the intent to change something for the better, i.e., the delta in the outcome, combined with the understanding that this reduces long-term (ESG) risks; sustainability can be something that affects people or the planet incidentally, i.e., a positive byproduct.

Measurement currently poses one of the key challenges and should be done alongside financial return. The impact management project identified five dimensions that can be used for measurement:  outcome (is it positive or negative); who is affected (which stakeholders); how much (degree of change for stakeholders); contribution (company’s/ investors’ efforts lead to a positive change in outcome); risk (likelihood that outcome is different than expected). To make it more feasible for investors, many financial institutions refer to the UN goals for sustainable development for measurement (UN SDG). Making these links is without question a step into the right direction, but can also be problematic. Financial institutions may prefer investments that are easier to measure (e.g. a solar panel producer in Germany) with a clear and easily controllable carbon dioxide reduction, compared to an investment into a small power plant in Africa. A small power plant may not reduce the carbon footprint as much as an investment in Western Europe, but when it comes to changes for stakeholders, it makes much more difference through providing people with access to electricity and thus contributing to the reduction of poverty in the long run. Differentiating between generating positive and reducing negative impact and summing up the result sounds like a simple solution, but it’s very difficult to implement.

Besides developing measures and consensus on impact measurement as promoted by the Impact Management Project, a group of well-established companies that pursue a “forum for building global consensus on how to measure and manage impact,” there is strong movement in the start-up scene to link new business models with impact, like the start-up impact benchmark project. All of these initiatives focus on providing quantitative data that can accompany the financial data.

IMPACT AS ALTERNATIVE TO THE CLASSICAL PORTFOLIO THEORY?

As the COVID-related market turmoil in March 2020 has shown (as well as the current development that seems detached from any economic fundamentals), classical portfolio theory based on fundamental market data and focusing on low correlations and diversification approaches seems to be a last-century concept. With global value chains and increasing interdependencies of countries and regions, regional diversification no longer provides the desired result in challenging times. Though the risk aspect of diversification does not hold up any longer, it is still a very valid approach for participating in a bull market.

A different approach may be to construct portfolios that focus not only on the risk/return optimization of the capital asset pricing model (CAPM), but also on the underlying desires of the investors. Of course, having a portfolio that serves “the greater good” won’t balance out poor financial performance, but fostering measures of success other than market benchmarks can make pure profit maximization less appealing.

If we consider that most investors are looking for wealth preservation rather than active asset growth (often called the “thrill and fun” aspect of active trading), the highest financial return is not necessarily the most important aspect of the portfolio. Wealth preservation requires more of a risk rather than return approach. Instead of higher returns, the next generation of investors is much more interested in the purpose of their investments. Investing their money to make a difference is at the core of their needs. This shift is seen not only from previous generations to Generation Y, but also from male to female investors.

Crucially, this difference must go beyond storytelling and well-illustrated brochures, as the well-educated investor will see this as a marketing campaign rather than an approach that effectively addresses their needs. An in-depth understanding of the clients’ needs and values is essential and forms the center of the portfolio construction.

What are retail clients looking for when they invest? What should a solution that really addresses their needs look like? Read more in part II of this series.