Are you concerned about climate change? Wish that corporations would give more resources back to their communities? Think companies should have a more diverse workforce? Investors are increasingly looking to align their investment portfolios with their personal values, and if you answered yes to any of those questions, Impact investing may be the investment philosophy for you. But what is impact investing?

Impact investing generally comes in two flavors:

1. “Negative screening”, which attempts to avoid investments in controversial business practices (from fossil fuel production to the manufacture and distribution of alcohol, tobacco, firearms, from private prisons to adult entertainment); and

2. “Positive influence”, which includes targeted investments in companies that are producing measurable environmental or social change.

What is the value of negative screening?

Before making any investment, it makes sense to do some research on the company in which you’ll be investing. Does it have a unique product? Is it profitable? Can it continue to expand sales into new markets? All of these are important criteria, but recent research has shown that integrating environmental, social, and governance (ESG) factors into that evaluation can provide long-term investment value beyond just looking at financial factors. And this makes sense: companies that are focused on reducing their carbon footprint and eliminating waste (environmental), eliminating customer and employee controversies and controversial business practices (social), and increasing their transparency and removing conflicts of interest (governance) should attract more loyal customers and high quality employees- factors essential to long-term outperformance.

What's the value of positive influence?

Rather than just screening out companies you don’t want in your portfolio, impact investing also gives you the ability to invest directly in companies and themes – like green energy, clean water, and affordable housing – that you do care about. This approach also requires using ESG factors to identify those companies with a strong commitment to creating positive change.

But now that we’ve defined ESG, how do we identify investment managers that are incorporating these factors into their research process? Many asset management firms have adopted ESG principles, but the implementation remains more of an art than a science.

 We look at 5 key selection criteria for identifying and evaluating the best-in-class of these managers:

1. Reputable source of ESG data: First, we have to know that the investment manager has an independent source of ESG data. Unlike financial data, which is standardized and required for public companies, ESG data is still ad hoc, non-uniform, and only provided on a best-efforts basis. It’s therefore important to rely on expert analysts to uncover and evaluate this data.

2. Clear process for rating sustainability: Everyone has their own interpretation of “sustainability”, and we’re not here to say one definition is better than another. What we look for is that the investment manager has a documented definition and a proven ability to apply that definition to every holding in their portfolio and every holding under analysis.

3. Process in place for monitoring portfolio positions for ESG compliance: Just as important as identifying the right positions for an impact portfolio is monitoring those positions for adherence to ESG criteria. It is essential that investment managers have a qualified team in place to review each position on an ongoing basis.

4. Sell discipline associated with ESG metrics: This is an extension of the previous criteria and requires that an investment manager have a process in place for identifying companies who fail to meet the managers’ string ESG criteria and removing those positions from the portfolio.

5. Investment team has ESG experience: Regardless of whether the asset manager is conducting in-house due diligence or is leveraging research from a third-party, it is crucial that the investment team have a firm foundation in socially responsible investing and the use of ESG factors. Even as recently as ten years ago this wasn’t a guarantee, but programs through US SIF and improvements to the CFA and CIMA curriculum have made learning ESG more accessible to analysts, portfolio managers, and other investment professionals.

It is possible to do good while doing well by investing your portfolio in line with your values, but not every ESG portfolio meets the rigorous criteria outlined above. By incorporating these questions into your investment due diligence, we believe you can identify those asset managers who truly believe in the value of impact investing.

The information, analysis, and opinions expressed herein are for informational purposes only. Nothing contained in this piece is intended to constitute legal, tax, accounting, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type.

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