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Impact Investing – How to Assess Performance

February 24, 2022

In the summer of 2021, BDF introduced our Impact Investing platform. We designed a portfolio that stayed true to BDF’s philosophy on investing while also emphasizing companies that score favorably in terms of their environmental, social, and governance (ESG) factors. Since this introduction, we’ve been fortunate enough to have many great conversations with clients who wanted to learn more about this approach to investing and how it might fit into their financial plan.

The most popular question that we’ve been asked is about investment performance. People want to know how adopting this type of strategy may affect their short-term and long-term results. Will companies that are doing good in the world also do well in their portfolio? Or is there an inherent trade-off? Is there a price to be paid to minimize your environmental impact? We’ll look closely at three different schools of thought and offer a framework to consider what adopting an Impact portfolio could mean for your bottom line.

1. Classic Efficient Market Theory

When the first funds that incorporated ESG criteria were launched, the prevailing sentiment amongst investing experts was that they should be expected to lag comparable funds with no such filters. The reason for this assumption was that the stock market is supposed to be efficient. Anyone constructing a portfolio should choose from the widest possible universe of stocks. The bigger the pool of available stocks, the higher the expected return should be. So, if a portfolio with environmental factors is going to limit or completely exclude certain market sectors, it should have a lower expected return than its counterpart with no such concerns. While this doesn’t seem to be the prevailing consensus any longer, there certainly are still market-watchers who believe this efficient market theory to be true.

2. Performance Neutral Theory

There’s a growing consensus amongst some of the largest money managers in the world that a socially responsible or environmentally friendly portfolio will have no impact on the return of a portfolio. For example, Dimensional Fund Advisors studied different metrics for firms’ emissions and compared them to the returns of their stocks and bonds over a long period of time. They could not find a reliable link between the two. Similarly, Vanguard has completed research that says ESG funds have neither higher nor lower returns and risk compared to the broad market.

3. An Endorsement of ESG Investing

Proponents of incorporating ESG factors into portfolio construction believe that these types of companies are less likely to be mired in controversy. They’ll have a lower cost of capital, and their stock could trade at a premium as investors will prioritize their attributes. These advocates will point to studies that suggest companies with strong scores have outperformed their counterparts with less favorable evaluations. Advocates of this research include BlackRock, a global behemoth whose CEO frequently makes ESG a major part of his annual letter to shareholders.

Only time will tell which of these schools of thought is the correct assessment of ESG investing. But for those still on the fence or getting comfortable with the idea of adding these factors into their portfolio, there is a growing body of evidence from credible sources to suggest that, at a minimum, their investment results will not suffer. In the meantime, BDF will be closely monitoring opportunities within ESG investing, ever mindful of the potential trade-offs of risk and return.