How possible is portfolio diversification with impact investing
As many financial planners attest to, diversification is one of the fundamental elements in a sound portfolio strategy.
In simple terms, it is avoiding putting all your investment eggs in one basket. And the reasons for this are obvious - if, for example, you put all your money into one industry or sector or part of the world, then, if they suffer or hit a downturn, so will the value of your whole portfolio.
If, on the other hand, you have a broad range of investments, then, not only will your exposure be limited, but often falls in the value of one sector will be compensated by rises in another, as investors around the world seek better returns.
The traditional diversified investment fund approach went for a combination of bonds and equities to maximise the potential for a smooth return over the medium to long-term. This traditional balanced fund often used for pensions, is split typically 60/40 between the two major asset classes of bonds and equities.
However, in whatinvestment.co.uk, Mike Brooks and Tony Foster, lead managers of the Aberdeen Diversified Income & Growth Trust, argue that investors looking to achieve a good level of income and growth now need to consider more than the traditional mix of bonds and equities and should be looking at a multi-asset approach to investing.
Firstly, the unprecedented monetary easing policies followed by central banks around the world since the banking crisis have pushed bond yields to historic lows, and negative territory in some countries means Government bonds are unlikely to produce the high returns of the past.
Secondly, while equity markets benefited from those monetary easing policies, driving them to new highs, this has been despite generally challenging economic conditions and there are risks to equity markets which could resurface when the support from central banks tapers off. This was prescient of Brooks and Foster when they wrote in May 2018, as since then, central banks have begun to unwind monetary easing and, over the same period, equity markets have been falling, a decline which accelerated in the final months of 2018.
To achieve the necessary portfolio diversification in this more challenging environment, Brooks and Foster recommend a much greater spread of asset classes.
The question for the investor looking at impact investments to play a part in such diversification, is - is there a sufficient range of impact investment opportunities out there?
At one time the answer to that would have been a simple no. It was generally believed that impact or ethical investments were limited to those which avoided backing activities generally seen as harmful, or which only supported a limited range of activities and projects, such as those with an obvious philanthropic element or with some kind of environmental angle.
However, in recent years there has been a growing recognition that impact investments can cover a much broader range of activities.
There’s now a general agreement on four elements that make up an impact investment:
- It should be an active and intentional deployment of capital
- The impact created by the investment should be measurable
- There should be a positive correlation between the intended impact and an investment’s expected return
- It should have a net positive effect on society and the natural environment
This is a broad definition and allows for the inclusion of a whole range of investment activities, which the casual investor wouldn’t perhaps have recognised as being impact investments.
In an article in the FT, Mark Haefele, chief investment officer of UBS global wealth management, makes the point that, in the past, sustainable and impact investing (SII) was unfairly and unfavourably compared to regular or traditional investing, by limiting its definition to “exclusion” investing or the exclusion of ethically questionable investments. However, as we’ve seen, SII - or impact investing - is no longer just about avoiding certain socially harmful activities.
With impact investing it’s a question of backing good things. Impact investments are made in businesses or projects that have a positive social impact, which could, for example, be providing clean water, clean energy, life savings drugs or education.
The World Bank says:
“ESG investing is increasingly becoming part of the mainstream investment process for fixed income investors, as opposed to a specialist, segregated activity, often confined to green bonds.’’
Impact investments don’t have to be in headline grabbing projects. Every year, hundreds of highly innovative businesses start up, which are seeking early stage funding for work in fields such as health research, clean energy, education and training. Any portfolio should include some investments in higher risk, higher growth businesses and these can be provided by impact investments.
Arguably safer, but also an important part of any diversified portfolio, is property. Housing is a sector in which there’s huge potential for impact investing to make a difference, not only in relieving homelessness and improving quality of life, but also in providing economic stimulus, jobs and training and in regenerating communities.
So there are plenty of impact investment opportunities for them to be able to play a part in diversified portfolio, but do they give good returns?
The answer to that is that impact investments give returns which are at least as good as those provided by non-impact investments.
As long ago as 2005, Zakri Bello published a study: Socially Responsible Investing and Portfolio Diversification. He summarised his findings:
“I use a sample of socially responsible stock mutual funds matched to randomly selected conventional funds of similar net assets to investigate differences in characteristics of assets held, portfolio diversification, and variable effects of diversification on investment performance. I find that socially responsible funds do not differ significantly from conventional funds in terms of any of these attributes. Moreover, the effect of diversification on investment performance is not different between the two groups.’’
This was just one of many studies coming to the same conclusion. For example, a survey by the Global Impact Investing Network (GIIN) and JPMorgan, found that 55% of impact investment opportunities result in competitive, market rate returns.
It should, therefore, come as no surprise to learn that that’s where the smart money is heading. In a new report Return on Values, UBS Wealth Management UK surveyed more than 5,300 investors in 10 markets on sustainable investing. It found that 39% hold sustainable investments in their portfolios, defined as at least 1% of their investable assets.
Not only that, but the adoption of sustainable investing is expected to grow significantly to 48% over the next five years. Additionally, many investors expect to increase the allocation of sustainable investments in their portfolios - in fact, 58% of investors expect sustainable investing to become the standard approach to investing in 10 years.
Therefore, looking back to our original question, portfolio diversification is not only possible with impact investing, but impact investments can be an enabler of diversification and make it a more profitable investment route for many.