Traditional portfolio management theory says that every investment decision has a certain expected return and a certain expected risk, and that these tend to correlate. But an investment decision is also a capital allocation decision. The amount invested flows to the user of the capital, the investee. In the case of equity investment, it influences the flow of capital to the investee through cost of capital.
The use of capital by the investee creates an impact in terms of sustainable development that can be measured and managed.
Investment impact can also be understood as the third dimension to the previously two-dimensional modern portfolio theory based on risk and return.
Let's say you lend your friend 50 pounds, and he promises to pay it back in a week and buy you a nice cup of tea in return for the favour. The cup of tea is your expected return. Let's say there is small chance that your friend falls short and you lose the 50 pounds and the cup of tea. This is your expected risk. If you think your friend falling short is likely, you might want to ask for a cup of tea and a nice sandwich to compensate for that greater risk. This is how investment return and risk tend to correlate.
Unrelated to either of these is what your friend decides to do with the 50 pounds. Maybe he has been unemployed for a while, and he uses the money to buy new clothes for his upcoming interview. Armed with the help of the new clothes (and the accompanied self-confidence) he gets the job. Or maybe he decides to buy himself a DVD box set of his favourite TV show that he binge watches over the week, forgetting his job interview. Two very different outcomes, which constitute your investment impact.
This is how it works in a bigger context as well. When your savings, your pension, your insurance premiums, the sovereign wealth of your country, the endowment capital of your university, or any other wealth you invest (or is invested on your behalf) in capital markets, it creates an impact in terms of sustainable development. This impact can be either positive or negative, but most importantly, it exists (just like risk and return) regardless of whether you pay any attention to it.
It is a way to understand the impact of any one investment decision in terms of sustainable development. Various portfolio impact footprint tools exist in the market. We like to think of Impact Cubed Impact Measurement as being one of, if not the, best.
Sustainable development in general has many definitions but the most widely used one was formulated by the Brundlandt commission in the late 80's saying, 'Sustainable development is development that meets the needs of the present without compromising the ability of future generations to meet their own needs.' This is obviously intellectually solid way of describing the concept but it is also too abstract to be used in measuring investment impact. Sustainable Development Goals (SDG's) approved by UN General Assembly in 2015 lists 17 goals and 169 targets to define what the 'development without compromising the future generations' mean for the present generation. This gives the investment community (and Impact Cubed) a meaningful framework to measure and manage sustainable investment impact. While any set of quantitative indicators cannot capture the full complexity of the 'needs of the future generations', we are confident that our selection of indicators takes us 99% there.
Find more information about Sustainable Development Goals at http://www.un.org/sustainabledevelopment/sustainable-development-goals/
It is based on well-established models of investment risk measurement. It basically measures the investment exposure to a set of ESG factors and uses that to determine what portion of the total risk was used to reach the ESG exposure.
Every investment decision, alongside its commonly measured and reported risk and return, also has an impact in terms of sustainability. This impact exists regardless of whether the investor is aware of it or not. And since what gets measured gets managed, impact measurement is a crucial departure point for managing the impact of our investments.
Individuals have three ways to influence the world at large. How they vote, how they consume, and how they invest. The importance of voting is well understood and even taught in primary schools. The importance of consumption decisions is less applied and understood, but nevertheless well established in public sphere. Compared to these the influence of investment decisions is poorly understood, applied and communicated. Measuring the impact is the first step in managing it.
More importantly, through the relative size and power of multinational corporations, and their sensitivity to access to capital, the influence of our investment decisions is multiplied.
The bottom-line is that your carefully considered and cultivated voting and consumer choices can be cancelled out by your investment decisions. Or by the investment decisions that are done on your behalf by your pension plan, your university endowment, your congregation, your municipality or your nations sovereign wealth. Auriel has published some white papers on this topic. They are available at http://www.aurielequities.com/auriel-equities-in-the-news/ if you are interested to know more.
All models are wrong, some are useful - Edward Box
Quantifying inherently qualitative issues like the needs of the future generations will always come with some unavoidable amount of error. A decade ago these models and the data they relied on was plagued with bad quality, costly to obtain, and difficult to use. Nowadays the situation is very different. There are thousands of companies reporting on their impact; their carbon emissions and water use for example. This corporate reporting is improving both in quality and quantity, making impact measurement more accurate today and even more accurate going forward.
Is it perfect? Probably not. Is it useful? Definitely. Well beyond point of being actionable.
The outcome of the model is simple and there are plenty of applications for it. For example, one can compare the impact of different investment strategies against each other, or the sustainability of investing in different markets. The model can also be used to measure the combined impact of all investments in several portfolios, or to attribute the impact of one portfolio to a combined portfolio. It can establish an impact from investing in one company (which from a model point of view is just a portfolio of one company), so that individual portfolio managers can use this framework to understand how investing in one company influences the overall impact of the portfolio.
There are a few commercial 'SDG Measurement' and 'Impact Measurement' tools and frameworks available commercially. Some asset managers have also established in-house methods that they use to communicate how sustainable their portfolios are. Most of the existing models have their merits, but we would suggest looking out for few things.
Some models and funds are 'one trick ponies', they might take care of one aspect of sustainability (like climate) and pay no attention to others (like gender) and vice versa.
If the model uses proprietary inputs, for example composite sustainability ratings, there are two things to consider. First, be aware that you are buying in to someone's opinion. Second, by using proprietary data the model outcome is much harder to verify from outside.
Most organisations providing (sustainable) financial services have an intensive to explain their operations to be as sustainable or impactful as possible. Without a balanced, comprehensive model that considers all holdings of the portfolio, you are susceptible to being given the impression that investment in one company makes the whole portfolio sustainable.