If sustainable investment quarterly = (risk / return) + effect
Then, Impact = ESG alpha?
Sustainable investment space
Investors risk slices and dice to generate financial returns on investor capital. Sustainable investment capital claims increasing evidence that positive financial returns as well as positive effects are created. Once adopted by investors, transparent impact metrics will initiate a rotation in portfolios that will shift them from “negative impact” and “impact positive” investments.
This impact-driven rotation should produce environmental, social and governance (ESG) alpha for investors.
The effect is hot.
“In its simplest terms, impact is a measure of the benefits of an action for humans and the planet.” – Sir Ronald Cohen, Effect
Impact: Reshaping capitalism to drive real change Nominated by Sir Ronald Cohen as “Best Book in Economics 2020” Financial times. As the founder of Apex Partners, Cohen is no stranger to exploiting the risk of gaining a mouth watering return for investors. Since 1981, Apex Partners has been synonymous with global venture capital and private equity.
Now, as chairman of the Global Steering Group of Impact Investments, Cohen has become the champion by adopting a standardized accounting method for impact measurement – Impact-Weighted Accounting (IWA).
“Property owners are asking their asset managers to increase the amount of impact reports.” – The future of sustainability in investment management
The The future of sustainability in investment management The CFA Institute report devotes several sections to exploring impact objectives for investment products and emphasizes the need to adapt impact measurements.
The Financial Analyst Journal The prestigious 2020 Graham and Dodd Scroll Award presents George Seraphim’s “Public Sentiment and the Price of Corporate Sustainability.” Serafeim describes a long-short ESG strategy that focuses on public sentiment that creates “significant positive alpha”. ESG can be a proxy for realizing the impact of public perception in space.
So, what is the formula for the sustainable investment trilogy?
1. The amount of risk
Investment managers regularly calculate the “risk-adjusted returns” of their portfolios. Sharp Ratio uses price volatility – portfolio standard deviation – as a quantitative metric for risk. But this risk proxy is only valid if the data series has a normal distribution. Beware of black swans! However, which period did you choose?
The SASB-Sustainability Accounting Standard discloses board-industry-specific accounting standards and related technical metrics that can be a sustainable risk and a financial component for investors. Climate risks, carbon risks, cyber risks, reputation risks, regulatory risks, stuck assets, and the risk of losing a social license to operate, among many other, sustainable risks, join the risks that investment professionals manage.
So get up to speed on the risk of financial-overall stability hidden in your portfolio before some of your assets get stuck.
2. Input return
“Return” is a concept filled with similarly defined challenges. What time horizon? Total or net? What’s fake? All costs and fees, or just some of them? How should the currency be handled?
Indeed, in 1987, the Global Investment Performance Standards (GIPS) was created to overcome the difficulties that investors face in obtaining accurate investment performance data. CFA Magazine “A Novel Idea” was published in 2007 to celebrate the 20th anniversary of GIPS.
A voluntary standard, constantly revised since its introduction, GIPS has yet to achieve industry-wide adoption.
So how are financial returns reported on your personal investment portfolio? What sustainability risks are you financing to achieve that return?
3. Effect measurement
Seraphim and his team at Harvard Business School have published a series of detailed papers on the quantitative approach behind Impact-Weighted Accounting (IWA). With open-source transparency, IWA eliminates the possibility of “impact-washing”.
SASB, GRI, and the Global Impact Investing Network (GIIN) have metrics for long-term policy and sustainability reporting. In addition to these organizations, as part of the Impact Management Project, IWA takes these metrics one step further by monetizing these metrics.
Using publicly available data, IWA translates all kinds of social and environmental impacts into comparable, decision-making financial units that business managers and investors can intuitively understand. Importantly, IWA demonstrates financial and impact performance on the same account. This allows the use of existing financial and business analysis tools to assess corporate performance.
For example, let’s compare the environmental effects of Coca-Cola and PepsiCo’s competitive activities using IWA. PepsiCo reported 2018 billion dollars and net income of ১২ 12 billion in 2018, double that of Coca-Cola, which was .81..8 billion and 6 6 billion, respectively.
IWA 1. PepsiCo’s 201 operations at billion 1 billion monetize the estimated negative environmental impacts of operations, similar to Coca-Cola’s .7 1.7 billion. In both cases, these costs are almost entirely responsible for the inefficiency of water use, according to the IWA’s “Corporate Environmental Impact: Data Supplement”. If the negative environmental impact of Coca-Cola’s activities is spent on an accounting line-item, the company’s 2018 net profit will fall by 28%.
Consider the effects of employment. How will labor be managed if it is classified as an asset instead of an expense in the financial statements? Companies invest and retain assets to create high quality returns. Not so with spending, which is a cost to reduce if possible.
Does the quality of the wages and benefits a company pays create value for society? As a conclusion, does low wages and high reliance on contract workers derive value from society?
The IWA transparently monetizes the impact of a company’s employment practices. Similarly, the IWA measures product impact measures, financially, the inherent well-being of a company’s products – or the social and environmental impact caused by its lack, increased availability for insufficient population, and product safety, among other factors.
More than a dozen multinational corporations and institutional investors worldwide are applying the IWA method today. Participants in this market share the goal of a transparent, comparative, decision-making effect metrics. Property owners can use impact-weighted accounts as a manager-selection and monitoring tool to ensure that their allocation is integrated with impact.
Impact-weighted accounting is a missing element of an impact economy. Its arrival will prompt the portfolio to move away from “negative effects” and to “positive effects”. ESG Alpha should be unlocked for this impact driven investors.
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All posts are the author’s opinion. As such, they should not be construed as investment advice, or the opinions expressed do not necessarily reflect the views of the CFA Institute or the author’s employer.
Photo Credit: © Getty Images / Carles Navarro Persarisas
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