In a previous blog, I described the components of impact investing. It dealt with client concerns and argued that impact investing strategies typically do not give up returns. However, the flipside of the rigour of impact investing is that it does pose challenges in terms of the inclusion of assets. Then the wider concept of investing for sustainability outcomes comes into scope.
Investing for sustainability outcomes
Investing for sustainability outcomes refers to those approaches that aim to have positive sustainability outcomes, but where at least one of the criteria of impact investing (contribution, intentionality, and measurement) cannot be met.
For example, a company might have highly positive externalities, but doubtful intentionality. And in many fund of fund private investments, the measurement cannot be done, which in turn makes contribution and intentionality challenging. Quite a few assets are in this grey area, where positive sustainability outcomes are likely but not proven.
Calling this impact could be called “impact washing”, and hence the label ‘investing for sustainability outcomes’ is more appropriate, or avoiding the word impact altogether. Some of our clients would call this ‘making the world better’ or ‘investing for long term value’.
The investing for sustainability outcomes approach has the advantage that it can be applied more easily to an investor’s entire portfolio. It still means that significantly better social and environmental outcomes (ultimately leading to an economy within social and planetary boundaries) are the goal, but without the same level of rigour or transparency in meeting all three requirements. In a similar vein, the International Finance Corporation (IFC) distinguishes between ‘intended impact’ and ‘measured impact’.
The investing for sustainability outcomes approach also means that there is more scope to include companies with negative externalities, provided that they are on a credible transition pathway to eliminate their negative externalities. The latest ESMA Greenwashing Report (August 2023, page 41, point 99 on “Creating” impact, as opposed to “Buying” impact) goes quite far in making the case for including such transitioning companies:
“There are multiple ways for “creating” impact including financing the transition and supplying new capital by directly financing sustainable solutions. One notable example are funds buying “brown” (transitioning) companies and turning them “green”, then selling them for profit and reinvesting in other brown companies. The impact in this case is attributable to the investment strategy (e.g., successful engagement) and cannot be entirely ascertained based on a portfolio holdings analysis. The funds would disclose under Article 8 or Article 9 SFDR, subject to their meeting of Article 9 SFDR criteria and, in particular, that related to holding sustainable investments. It is very important to note that sound impact claims can come from such products trying to de-brown the economy and that these may confuse those who are not well versed investors.”
Clearly, inclusion of transitioning companies requires a very active role for the investor, with intense engagement and long holding periods for such holdings, even if they make up only a small part of the portfolio. See also: How to manage the unsustainable parts of your portfolio? Investing in (climate and other) transitions (schroders.com).
A client request example
How does it work? A client recently asked us to build a large equity model portfolio that will ‘encourage positive impact and reduce the negative impact of our investments’, along with 10-year market rate returns. We subsequently built a portfolio with three types of sustainability and sustainability outcome features:
Leaders: companies with highly positive externalities as evidenced by a high SustainEx score – our proprietary tool that measures externalities as a percentage of sales, see Attaching accurate values to S and E: why I joined Schroders.
SDG aligned: companies that contribute to the SDGs as evidenced by a high ThemEx score – our proprietary tool that measures sales exposures to the SDGs
Potential improvers: companies with low to moderately negative net externalities (as measured by the abovementioned SustainEx score) are eligible, provided that there is a credible engagement path – this is not a trivial matter, again see How to manage the unsustainable parts of your portfolio? Investing in (climate and other) transitions (schroders.com)
These types highlight yet another distinction within sustainability and impact portfolios: outcomes now (static and measurable) versus outcomes in the future (dynamic and to be measured). While the leaders and SDG-aligned companies offer outcomes both now and, in the future, the outcomes of the potential improvers lie squarely in the future (although backed up by current efforts of course).
 The underlying negative externalities can be quite significant, even if the net externality is moderately positive externality – it just means that there are large positive externalities as well. Ideally, the negative externalities are eliminated while preserving the positive externalities.
In this case, the client was looking for an alternative to unsatisfactory passive portfolios, and we built a portfolio of some 450 stocks, but of course a more concentrated portfolio is possible. In this portfolio, leaders account for half of assets while the potential improvers and SDG-aligned companies each account for about a quarter. Interestingly, this portfolio has financial characteristics like an index, but with demonstrably better current outcome characteristics: better externalities (8% points better SustainEx, i.e., better externalities in size of 8% of sales); higher exposure to the SDGs; and lower carbon intensity. Forward looking, the portfolio offers lower implied temperature rise, and higher expected reductions in negative externalities (from the potential improvers category).
Benefits for the client
In addition to the intended outcomes, this approach has several other advantages for clients. First, as universal owners, investors can remain invested across nearly all sectors, and do not evade their responsibility of helping companies transition to more sustainable business models (ESMA’s point of creating versus buying impact).
Second, by keeping exposure to ‘difficult’ sectors (be it very selectively!) investors can minimise traditional financial risks in terms of having a low tracking error and keeping sufficient exposure to the value factor.
Third, using sensitivity analyses, we can show the trade-offs between better outcomes and higher financial risks. Clients then know what levers they have and what the implications of their decisions are.
Fourth, exposures to hitherto under-priced financial risks such carbon (partly priced, see Do investors care about carbon risk? - ScienceDirect) and biodiversity (just starting to be priced, see Do Investors Care About Biodiversity? by Alexandre Garel, Arthur Romec, Zacharias Sautner, Alexander F. Wagner :: SSRN) are reduced.
Fifth, accountability to constituents is high. For such a portfolio of a few hundred stocks you can really know what you own. We have the frameworks and the analyst coverage to monitor them. And the storyline is relatively simple: we invest in those companies that already make nature and society better and in those that are serious about becoming positive contributors. Of course, only time will tell if the potential improvers are companies that can deliver on their outcome promises, hence the risk is not to be underestimated.
Combining both approaches
It goes without saying that impact investing and investing for sustainability outcomes do not exclude each other. After all, impact investments (all criteria met) can be part of an overall approach to investing for sustainability outcomes (criteria only partially met, like the IFC’s ‘intended impact’). Ideally that is done not just in a single asset class, but as part of an integrated approach to Strategic Asset Allocation.
That is the next frontier we are working on. The first part of this blog started with a quote by Winston Churchill on the extreme diversity of opinions among economists. I’m sure his quote will remain relevant as we will never get rid of diversity of opinion (and we shouldn’t!), but we can also conclude that thorough approaches to better sustainability outcomes are possible.
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