ESG and Impact Investing: Do You Know the Difference?

An ESG framework can be integrated in the risk/return analysis of investment opportunities. Drawing from a wealth of data — gathered from company disclosures, government databases and various other sources — it empowers investment professionals and their clients to examine how companies are managing risks and opportunities across three key areas. These are listed below, with examples of considerations that one might consider when assessing performance in each category:

• Environmental: How is the company disposing of hazardous waste? Is it managing carbon emissions? To what extent is it meeting environmental regulations? Is it testing products on, or otherwise harming, animals?
• Social: Does the company support philanthropic and community-focused initiatives? Is it partnering and working with third parties whose values align with those that it purports to embrace? Are employees provided with access to health care and other key benefits? Is leadership focused on promoting diversity?
• Governance: Are company leaders appropriately qualified for the role, and are they communicating a coherent strategic vision? Are their compensation packages appropriately aligned with performance? Is the C-suite communicating effectively, and transparently, with shareholders?

One thing that's key to note: As an advisor that is utilizing ESG criteria when making investment decisions on behalf of your client, you are still empowered to purchase a security (unless it has been explicitly restricted by said client) — regardless of its effect on the environment or society. For example, you might assess the probability that big oil companies' carbon assets become stranded during their holding period. The resultant probability is incorporated into the investment's cash flow projections and discount rate. If the risk/return output is acceptable to you as the advisor, and falls within client guidelines, you can make the investment on behalf of the client.

To conclude: an ESG framework is a valuable tool that may be utilized to evaluate how certain responsible behaviors positively affect a company's performance, and subsequently drive investing decisions. It is not, however, a strategy in and of itself.

Impact Investing

Neighborly's work in communities across the country has demonstrated a strong appetite among individual investors for innovative, sustainable opportunities that directly address social and environmental issues. The enthusiasm we've witnessed in locations such as Cambridge, Massachusetts, and Burlington, Vermont, has pointed to one thing: a growing desire among investors to do well by doing good. That's where impact investing comes in.

Impact investing focuses on utilizing capital with the specific intent of effecting positive social and/or environmental change, while simultaneously generating strong returns. And, contrary to outdated narratives, the two needn't be mutually exclusive! In fact, data increasingly suggests that funds with purported impact missions generate comparable ROI when assessed against those that are focused solely on optimal returns.

As an advisor, impact investing enables you to differentiate your practice by providing compelling mandates such as support of expanded access to clean energy, the creation of resilient infrastructure, or enhanced social and economic mobility of underprivileged communities. Consider presenting an investment mandate to your clients that allows them to fight climate change, or another issue that they place in high regard — it's a pretty powerful message.

However, while the provision of an impact investing strategy is undoubtedly a powerful marketing tool, it's important that you take time to educate yourself — and subsequently your clients — as to the associated risks. There is the possibility that certain opportunities may underperform relative to other widely available options; investors may also be exposed to liquidity risk and experience difficulty exiting the investment under certain circumstances. Financials aside, there is a chance that the intended social impact goals may not be achieved, and the initiatives that clients had hoped to see come to fruition are not realized. It's imperative that you have an honest conversation with them to evaluate goals, and appropriately manage expectations.

As impact investing moves toward the mainstream, and increasingly represents a core offering rather than a "nice to have," it's imperative that advisors who wish to remain competitive take the time to understand its core elements now. The impact revolution is already underway, and you don't want to be left behind.