Impact via Public Equities (4 of 6)

The public equities domain represents an important piece in the quest of broadening the plumbing of impact investing for three main reasons: scale, accessibility, and liquidity. Public equities tend to be issued by corporations that have a certain scale to their operations. By the time an IPO or stock issuance comes to market, the company will have already gone through various stages of funding bringing either scale or promise of prior to hitting the public markets. And with public markets come accessibility and liquidity where investors of all types can participate, invest, and divest. Public markets can represent a more efficient use of capital. Vast amounts of money can go in and out of investment structures, and the public nature of the market assures liquidity and lower management fees. Blackrock’s newly launched Global Impact Fund with $38 billion as of July 9, 2020 (Blackrock 2020) investing in equities has an estimated 0.75% total annual cost to run (called Ongoing Charges Figure). By comparison, PE funds typically cost LPs 1.5%-2.5% plus 20% of the upside once original capital has been returned, a significantly more expensive investment structure.

Impact Investing and Portfolio Management: A Journey from Two to Three Dimensions

The tension that exists between financial and impact returns is a natural and long-established debate. Even though for the most part there is a tradeoff between the two, it is not always the case. Some portfolio trading strategies that incorporate ESG or impact criteria can yield as good as, if not better, returns than traditional portfolios. This is especially true during times of economic stress such as Covid-19 where some ESG-guided indices and strategies have proven more resilient to downturns, which is understandable. Companies that score higher on sustainability metrics tend to be better run, operate more efficiently, be better risk managers, have more committed employees, and have more resilient supply chains.

But let us assume for a moment that there is a tradeoff between financial return and impact. Portfolio investing focuses on combining financial assets in a way that return is maximized for a certain level of risk, or risk is minimized for a certain level of return. Even though the composition of a given portfolio can be complex and involves a multitude of securities with various degrees of correlation, it is by and large a two-dimensional exercise between risk and return. Modern Portfolio Theory will tell you that there are efficient frontiers, minimum variance portfolios (“MVP”), optimal risky portfolios (“ORP”), and capital allocation lines (“CAL”) as described in Figure 7. These concepts are factored in the process of maximizing the risk-reward equation. Those that are highly skilled can extract excess returns or alpha. It is both a statistical and a modeling exercise following established principles.

 Figure 7. Source: Prof. Alok Kumar, Chair Department of Finance, University of Miami

When we start looking at portfolio management through impact lens, the analysis goes from a two-dimensional exercise to, at least, a three-dimensional one as impact is incorporated into the risk and return chart. There are two main ways to assemble a portfolio of public equities designed for impact: 

1. Screen the universe of investable equities for impact first, and then apply portfolio theory to the subset attained.
2. Use a three-dimensional approach that works under a set of portfolio characteristics bound by three axles.

The first approach was used more recently by Wellington Investment Management when it devised its Global Impact fun whereby an investable universe of 450 companies was initially defined and then was further filtered to 50-70 companies (see Wellington case summary and analysis further down). Thereon it becomes a traditional portfolio management exercise where securities are combined according to pre-defined risk and return criteria as well as correlations. It becomes a simpler exercise to concentrate on the risk and return balance within a pre-selected impact subset, even though impact metrics still need to be tracked on the aggregate. Impact investors may be bound by social and environmental metrics sought at the portfolio level hence the selection of securities needs to be weighed against those metrics.

The second approach follows a more dynamic exercise where portfolio variables are constantly combined, balanced, and rebalanced to meet impact, risk, and return thresholds. The approach was outlined by Yasemin Saltuk, Director of Research, J.P. Morgan Social Finance in 2012 and showcased in a World Economic Forum report (Saltuk 2012). Figure 8 below shows the tridimensionality as impact is added. Investments that fall into the gray area would be eligible as they would be within the boundaries of pre-defined return-risk-impact parameters. 

Figure 8. Source: JP Morgan

Figure 9 exemplifies in blue lines one such investment within the gray zone.

Figure 9. Source: JP Morgan

Saltuk recommends that the portfolio exercise be kept simple and within 3 dimensions. However, if variables must be broken down, a six-dimension portfolio might look the following:

Figure 10. Source: JP Morgan

Saltuk also suggests that when defining the financial parameters of the target portfolio, the tradeoff between impact and return be left aside and that the focus be on economic analysis on a deal by deal basis, and that risk-adjusted expectations be set at that point.

Once return-risk-impact graphs for each investment are defined, their consolidation into a single graph will provide the portfolio characteristics that should be monitored over time. The balancing and rebalancing of a multidimensional impact portfolio is not an easy endeavor since every change to the portfolio will affect the aggregate metrics. Therefore, it should be benchmarked against realistic terms and be kept as simple as possible, e.g. favoring a tri-dimensional approach as opposed to multiple dimensional approaches.

The Wellington case summary and analysis below portrays a portfolio management approach where a “home” or subset of investable securities is defined prior to the risk/return analysis (option #1 outlined above). This is done by focusing on themes which when combined with other criteria will yield the investable universe.

Case in Point: Wellington Global Impact - Finding a Home Base for an Impact Portfolio. Based on Harvard Business School case study Wellington Global Impact.

Wellington Global Impact is a recent public equity impact offering whose development started in 2014 by Wellington Management Company (“WL”), a large investment management company with over $1 trillion in assets under management (Cole & Schenk 2018). There was a lack of impact investing alternatives in the market beyond private placements available to both retail and institutional investors. Upon initial analysis and interest in furthering ESG, the WL team embarked on the research and creation of investing themes designed for impact. They were divided into three categories as follows:

1.Life Essentials

Affordable Housing; Clean Water and Sanitation; Sustainable Agriculture & Nutrition; Health.

2. Human Empowerment

Education & Job Training; Digital Divide; Financial Inclusion; Environment.

3. Alternative Energy

Resource Efficiency; Resource Stewardship

The team then created criteria for inclusion in the investable universe around the notions of core activity (more than 50% of the company’s activities aligned with a given impact theme) and additionality (other companies were unlikely to meet the impact need). The initially identified investable universe was made up of 450 stocks analyzed and selected one by one. This was no easy task. Besides carefully designing a methodology that would survive the scrutiny of potential retail and institutional investors (“Impact Fiduciaries”), the team had to analyze a large number of companies through publicly available information, often supplemented with due diligence calls with each company to come up with the investable universe. That universe was then further slimmed down to 50-70 companies meeting both impact and risk/return criteria (“Financial Fiduciaries”). Sample companies cited in the case were Teladoc Health Inc. delivering low cost health services to US consumers including telemedicine (TDOC) and Safaricom Ltd (SCOM.NR), a Kenyan telecommunications company best known for its mobile payment product M-pesa. While Teladoc’s impact consists of reduced and improved healthcare costs (and put to good use during Covid-19), Safaricom’s consists of economic and social empowerment by having access to financial services (Cole & Schenk 2018).

The team had indication it was on the right track when the UN published the Sustainable Development Goals in 2015 outlining 17 themes for sustainable development. It was deemed there was considerable overlap between what the WL team was creating and what the UN launched. 

The idea was that public equity impact investing had the potential to bring scale and accessibility to a nascent market that was going beyond SRI or ESG filters, guidelines, and processes (which already existed in the market) to verifiable, actively managed, and carefully screened impact investing. It can be said it has the advantage of democratizing impact investing since private placements are rarely available to retail investors. Still, impact investing through public equities has its limitations, in particular on the measurement side given the more limited access to companies and management teams (Cole & Schenk 2018). For Teladoc and Safaricom, certain high level metrics were identified as depicted in Figure 11 below.

Figure 11. Source: Harvard Business School

As first movers in the impact industry, however, the undertaking by WL was not without risks among them:

• Information risk: ESG information to the degree that WL needed was not easy to come by or generate back in 2014/15. As a nascent industry, data was not widely available. Hence, it was time-consuming to identify and track the right information.
• Performance risk: despite early indication that portfolio performance was generating alpha and securities had the proper correlations, the portfolio had not gone through a downturn in the economy prior to its launch. Furthermore, it did not have a 3-year track record yet, a market benchmark for adoption. A quick visit to WL’s site however shows that the modeling appears to have been sound after all. Figure 12 below reports on the performance of the Global Impact Fund through early 2020 showing alpha over the MSCI AC World index.

Figure 12. Source: Wellington Funds

• Political risk: as stated in the HBS case, the election of President Trump put a damper on the Global Impact Fund for 2016-early 2017 as investor interest was skewed towards non-sustainable securities such as oil, gas, and coal among others.
• Adoption risk: as first movers, there is always the risk that investors may be slow in adopting the new product, which certainly seems to have been the case with the Global Impact Fund. As of the writing of this article, it only has $313M in assets under management, a small amount for a firm such as WL. The firm, however, did launch a sister fund, the Global Impact Bond Fund in 2019 which is now $78M in AUM (Wellington Capital 2020). 

Wellington Global Impact is an example of an impact-driven public equities strategy using a subset of equities or "home" to the portfolio. It does a reasonable job ticking the four boxes of impact investing we saw in the previous paper: intentionality, financial returns, asset class, and measurement, though the latter could certainly be improved with additional detail and layers of impact metrics. However, as more ESG information is made available by companies' pro-active reporting impact investing strategies in public equities should be able to further drill down on metrics.

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Works cited:

Cole, Shawn, and Lynn Schenk. "Wellington Global Impact." Harvard Business School Case 218-067, February 2018. (Revised October 2018.)

Shakin, Jim. “Global Impact Fund.” Wellington Management, 1 June 2020, www.wellingtonfunds.com/en-at/institutional/funds/Global-Impact-Fund/USD-S-Acc-69G7

Yasemin Saltuk, Director of Research, J.P. Morgan Social Finance “4.1 A Portfolio Approach to Impact Investment: A Framework for Balancing Impact, Return and Risk.” Impact Investing – From Ideas to Practice, Pilots to Strategy, World Economic Forum article