One of the benefits of using impact investing and ESG strategies with clients is that it allows clients to connect with their investments around more than just financial considerations. Is the appreciation of knowing what you own reflective of a larger trend?
Has the move toward indexing led us to lose sight of what investing really is?
Though index investing has taken off only in the past two decades, the rise of ETFs and indexing have been tremendously influential on the personal investing marketplace. As "owning the market" has become commonplace, I suspect investors (and professionals to some extent) have become somewhat detached from the act of investing.
Investing, in its most basic sense is taking a client's money and giving it to a company in exchange for owning a percentage of that company. That company uses the invested money to fund any number of initiative, from new hires to research to marketing. The hope with each investment is that the company combines the invested capital with good business management to grow the value of the company and/ or pay dividends to the investors.
I know you know this. I’m spelling out the basics because, when we spend most of our days in the important minutia of helping clients, we occasionally lose sight of the basics. When we lose sight of what we do, we probably aren't communicating it well to our clients.
What do clients want?
Alongside the rise of indexing, we've also witnessed nascent popularity in crowdfunding small businesses through online conduits like IndieGoGo and Kickstarter. We’ve also seen a fascination for investing in specific well known companies with innovative but understandable business models (Tesla, Apple, and Facebook for example).
Clients want to use their capital for companies they understand and believe in. While indexing has made low cost (and arguably smarter) investing broadly available, it has also removed the compelling personal interest element from the investing equation. I'm not arguing that financial professionals should do whatever their clients want; in fact, often good advisors have to do the opposite. Financial advisors need to help clients make good, long term decisions and stay the course with those decisions, even when the market gets choppy. Here’s where impact investing comes in.
Where does impact investing fit in?
Impact investing, paired with deep conversations between advisor and client has not only the capacity to connect investments to values, but also to reconnect clients with what their invested capital does. By talking to clients about what they want their money to fund, and sharing stories of portfolio companies and the impact they have, advisors help clients understand their portfolios. In times of market volatility, when advisors have to help clients stay invested for the long term, clients that are more personally connected to their portfolios may be less likely to sell or make other hasty decisions. Behavioral investing expert, Dr. Daniel Crosby says, "I believe that investing in ways that correspond with our values will make investment management more real, more personal and possibly incent us to do the hard work of remaining patient and committed." Impact investing and good financial advice can encourage investor behavior that is good for both the investments and the investor.
Can you index with impact?
Kind of, but you’ll have to make some trade-offs.
You can buy index funds with ESG screens, which align investments to commonly held values more closely than non-ESG index funds do. This strategy is a step in the right direction but gives less options for personalization than active investing allows, and leaves less “tools” in the fund manager “impact toolbox”. For example, many index funds are not public players in the shareholder engagement space, and those that are cannot divest from an indexed holding if engagement does not go well. Many RIAs include both passive and active fund strategies in portfolios to find the right balance for each client.
A small but growing number of separate account management firms offer customized index-like portfolios that are personalized to the clients impact or values desires. Unlike index funds, those portfolios allow both customization for impact and the flexibility of selling out of a holding a client no longer wants to hold (for example if the company management changes course away from sustainable practices). To my knowledge none of these companies are active players in shareholder engagement.
11/27/18 Edited to add detail of indexing options in the “Can you index with impact?” section.