Director of Responsible Investing at Federated Hermes, leading ESG integration and engagement across $650 billion in global assets.
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If you find yourself questioning the famous proverb, “You can’t have your cake and eat it, too,” then you will appreciate one of the longstanding debates in impact investing. For years, people interested in investments that advance sustainable development have been told they must enjoy losing money. The prevailing opinion held that seeking a positive impact on a social or environmental issue has a negative one on the wallet. You simply can’t have it both ways.
Or can you? A stroll down Constitution Avenue on the Mall in Washington, D.C., will take you past the institution that has been dealing with two objectives for decades. In 1977, Congress tasked the Federal Reserve with cultivating low inflation and a healthy labor market. Economists affectionately refer to it as the “dual mandate.” That’s as big a precedent as you can get.
To be sure, the Fed’s job of minding two things at once is not easy. During periods of business cycle transition, its monetary policy can make investors feel as if they are hanging on for dear life. Economics is not just a science, but a dynamic one. Yet many would argue that the central bank offers a better system than famed financier J.P. Morgan strong-arming bankers into rescuing the markets in the panic of 1907.
The New Dual Mandate
The point here is that objectives often seem more oppositional than they really are in practical application. That’s been seen in the rise of sustainable and impact investing. Structured differently and taking a more diverse approach than their predecessors, many of these investment strategies are fulfilling their own dual mandate to balance nonfinancial and financial goals alike. In recent years, many sustainability-focused funds have provided strong returns relative to traditional products. Faced with the false choice between investments yielding positive returns and those seeking to make a difference in the world, the answer is increasingly “Why not both?”
The main argument against such a two-for-one is that financial connectivity and performance is quantifiable, while the environmental or social impact is not. Qualitative assessments certainly play a large role in judging sustainability criteria, and the regulatory tides on either side of the Atlantic differ. But including relevant environmental, social and governance (ESG) knowledge in the decision-making process can be potent.
Many a company with attractive valuations has floundered—or even foundered—due to self-inflicted ecological disasters, questionable human rights practices or inadequate internal controls. More and more, portfolio managers are using new information sources to recognize the symptoms of these material breakdowns with the same fervor they scour a balance sheet. But the application of material ESG information doesn’t have to be solely for prudent risk management. It also can serve specific client interests by identifying underappreciated investment opportunities in companies whose business models contribute to the real-world benefit of people and the planet over the long term.
Make That A Double?
Financial materiality in a broad sense considers how an ESG issue affects a company’s enterprise value. A popular example is the inward impact of climate change on a company’s useful life of physical assets and regulatory risk. Double materiality applies an intentional addition of considering the outward impact a company may have on society and the environment. Think of it in terms of net impact, or the balance of risk mitigation and innovative solutions. This dual objective has become more achievable with the emergence of corporate sustainability and impact reporting. The collection of nonfinancial information has become more sophisticated through alternative data and direct engagement with companies, leading to the consideration of new metrics in the security-selection process. Whether through creating proprietary tools or relying on outside expertise, firms are discovering they are becoming better at measuring and forecasting the multidimensional success of sustainability initiatives.
The basis of positive impact generally ties to the use of proceeds or a company’s products and the solutions they enable. Opportunities for betterment can include secular themes such as circular economy, improving health, agriculture and water supply, financial inclusion, clean energy and education. Many of these megatrends align well with the United Nations Sustainable Development Goals (SDGs), which make them future-focused opportunities. Organizations such as the Global Impact Investing Network (GIIN) and others have built frameworks to help stakeholders determine what to consider with impact management.
Two For One
Dual mandates work because they can balance each other. Here the Fed is again an apt model. After slashing rates to support those unable to work when Covid-19 arrived in force, it recently initiated a tightening cycle to help curb inflation. The balancing act, while tricky in terms of timing and magnitude, prevents policymakers from egregious policy errors. While you can make the case that the Fed should have hiked rates earlier to better manage inflation, we must remember it does eventually react to the weight of the evidence. The whole is indeed greater than the sum of its parts. A company that myopically considers only near-term profits or investors only attempting to predict the next quarter can be blinded to serious long-term headwinds that inclusion of ESG factors might unearth. Investors should no more ignore these than they should fight the Fed. The results can be equal drivers of underperformance.
Likewise, investment strategies designed with a single financial intention or the additionality of positive impact can both be right, depending on a client’s objective. The creation of long-term sustainable wealth comes down to identifying the healthiest stocks or issuance that are not accurately priced by the market. Duality can coexist in a spectrum of options that marry holistic economic, natural and human capital. Either/or propositions have become less aligned with the changing preferences of consumers who want to eat sustainably and digest the nutrients, too.
The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.
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