The growing popularity of impact investing presents many challenges to financial advisors, among them how to measure the results of those investments, which is not as simple as it sounds.
There is, of course, the monetary gain or loss for the investor, as well as the impact of the investment on the particular issue or population it’s targeting. But in addition there’s the “social return” for the investor, the so-called “warm glow effect,” that the investor feels after making such investments.
“People make impact investments for different reasons,” says Jeff Finkelman, research associate for impact investing at Athena Capital Advisors, an RIA with $6 billion in assets under management.
“It’s not just seeing the outcome they have on those that are affected by the investment but … insuring that the capital had the kind of impact the client was looking to generate.”
In other words, did the client feel good about doing good? The return is no longer defined in financial terms alone for the investor or its impact on the investment beneficiary.
Finkelman recommends that before investing a client’s money with a social purpose in mind, a wealth manager consult with his her client to understand why the investment is being made and identify the metrics to use to measure its success or failure.
For example, will an investment in a community development bank be measured based on the number of loans that it issues or the demographics of its borrower base such as income or race or another variable. “ “You want to identify those up front,” says Finkelman.
Wealth managers working with mutual funds or private equity funds on impact investments can collect that data from those managers. “There’s more of an onus on the impact manager … to provide data and results,” says David Lynch, president of Athena Capital Advisors, which caters to high-net-worth individuals and families as well as endowments and foundations.
“If it’s a mutual fund they want to keep your money; if it’s a private equity-style fund they‘re going to want to raise [capital for] a second and a third fund.”
Fund managers may get some support for that – or discouragement – when Morningstar releases its environmental, social and governance ratings on funds sometime in the coming weeks.
Measuring returns — however they’re defined — is not the only major challenge for wealth managers and advisors involved in impact investing. They should also be discussing with clients whether they prefer to restrict those investments to a particular fund or asset class or spread them across an entire portfolio, including stocks, bonds, cash, real estate and other investments.
“You don’t have to just buy that mutual fund and stop there,” says Lynch. But you do have to undertake due diligence when choosing an impact investment manager – whether they manage a mutual fund or private equity fund, says Lynch.
“We find there are situations where funds are being launched by those with a lot of program experience in impact-related initiatives but perhaps but not as much capital markets experience,” says Lynch. “You need to find management teams that have a blend of both …. some capital markets experience … as well as program-related experience … that they know how to deploy and execute a program once they raise the capital.” In addition, wealth managers and advisors need to make sure that a fund’s fees are fair and appropriate, that “the economic incentives are aligned,” says Lynch. In the case of a private equity fund, for example, advisors need to know the rate for performance before the management team can start taking material compensation, the so-called hurdle rate, as well as the lockup and liquidity profile. Are they “appropriate for the type of investing they’re doing?” asks Lynch.
Before an advisor or wealth manager focuses on any of these issues, Finkelman suggests that he or she help clients develop an investor policy statement that identifies the social impact issues most important to them. Then the manager can research the market for the assets that address those issues and feed that back into the portfolio management and construction process.
Advisors should consider all these suggestions from Athena Capital if they want to keep up with the growing popularity of impact investing, especially among the millennials they may want to attract as clients or employees to grow their business.
“The scales are starting to tip,” says Lynch, about the reception of impact investing versus traditional investing. “In the early days you had to give up some return if you wanted to do this. Now the scales are at least equally balanced.”
The walls between impact investing and philanthropy are also breaking down, says Finkelman. “Making grants is one way you can address certain issues. If you’re doing it with impact investing you’re taking another angle at the same issue … As the industry matures, people are starting to see it more as a spectrum rather than separate segments.”
And traditional investment managers are taking notice. Finkelman says in recent manager meetings he’s attended traditional investment managers are looking at the ESG risks involved in the industries they invest in. “It’s part of risk management.”
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