Meaningful or Misguided: Is There a Role for Impact Investing in Your Portfolio?

Socially Responsible Investment Strategies

In the past decade, more and more investment funds have been created with goals that go beyond strictly financial returns. Impact investing, also called sustainable, socially responsible or ESG (environmental, social, and governance) investing — has gone mainstream, as investors concerned about social and environmental health seek to put their money into companies that share their values. But while these investors may wish to effect meaningful change through investing, they still want to see healthy financial returns.

In recent years, investors have increasingly used their money as economic leverage to spur reductions in companies’ carbon footprints, to promote diversity and equity, and to influence decisions in executive suites and boardrooms. Both individual and institutional investors are funneling billions of dollars into the stocks and bonds of companies, mutual funds, exchange-traded funds and other investment vehicles — including hedge funds, private equity, and venture capital —that promise to do well by doing good.

It’s an investment formula that has rapidly gained popularity. Morningstar, Inc., reported that 2021 was a year of record-smashing growth in the sheer number of investment funds promising socially conscious investing. “The number of sustainable open-end and exchange-traded funds available to U.S. investors increased to 534 in 2021, up 36% from 2020,” Morningstar reported. “Over the year, 121 sustainable funds were launched, easily topping the previous high-water mark of 71 set in 2020.” (Morningstar has since reported an additional 21 sustainable funds were added in the first quarter of 2022, bringing the total to 555 in June.)

In dollar terms, Morningstar reported that sustainable funds attracted a record $69.2 billion in net flows in 2021, a 35% increase over the previous record set in 2020. Assets in sustainable funds hit a record $357 billion, more than four times the total of three years ago.

One enduring question is whether investors can pursue socially responsible investing without sacrificing their portfolio’s performance. While there continues to be much debate, and the jury is still out on how a bear market affects impact funds – many studies have claimed that it’s possible for investors to do both.

ESG Investing in Volatile Markets

A September 2021 Charles Schwab study is particularly salient. Relying on Morningstar data, Schwab researchers examined one-, three-, five-, and ten-year returns for ESG funds within the ten Morningstar categories with the most ESG assets. Their determination? “ESG has tended to perform very similarly and with very similar levels of risk to non-ESG approaches,” Schwab analysts found.

“The important lesson here,” the Schwab analysis reported, “is that there is no evidence that choosing ESG funds puts investors at any kind of disadvantage when it comes to risk or returns.”

Roiled by high inflation, a war in Ukraine, a lingering pandemic, supply-chain bottlenecks, and fears of recession, stock prices in 2022 have been troublingly volatile. Even so, Schwab’s study remains relevant. Its analysis encompassed six stock-market corrections and two bear markets since 2007.

Whether the market is currently up or down, investor interest in ESG-friendly companies and ESG-oriented funds, such as those focused on the energy transition, low-carbon or carbon-capture opportunities, or other “socially responsible” investment strategies, still creates opportunities to raise capital and attract investors.

The Greenwashing Effect

While nearly every investment house, brokerage, mutual fund, or asset manager now offers some version of a socially conscious investment style, it remains a challenge for investors to discern whether ESG investing is truly the central focus of such funds and the validity of the claimed impact of the investment program, or if their claims are little more than window dressing.

This concern has come to the forefront along with the number of “repurposed” funds entering the marketplace. Repurposed funds are essentially established, conventional funds that have been re-labeled as “sustainable” or “ESG”. Citing Morningstar research, Barrons reported in June that 65 repurposed funds have been launched since January 2019, accounting for more than one in eight of all U.S. sustainable funds and ETFs. (The rebranding phenomenon is even more pronounced in Europe where, according to Morningstar, 536 existing funds were repurposed as “sustainable” in 2021.)

With so many players jumping onto the ESG-investing bandwagon, the phenomenon of “greenwashing” — companies or investment funds making exaggerated claims to appear more environmentally and socially conscious than they actually are — has become a significant concern. For this reason in June 2021, the SEC formed the 22-member Climate and ESG Task Force to crack down on the practice.

In May 2022, the task force announced that it had made its first collar. The culprit was BNY Mellon, one of the country’s oldest banks. The SEC fined BNY Mellon $1.5 million for “misstatements and omissions about ESG considerations in making investment decisions for certain mutual funds that it managed.” BNY Mellon settled the investigation by paying a fine and agreeing to a cease-and-desist order and censure, but either admitted nor denied the misconduct.

Adam S. Aderton, Co-Chief of the SEC Enforcement Division’s Asset Management Unit and a member of the agency’s Climate and ESG Task Force, observed that investors “are increasingly focused on ESG considerations when making investment decisions.” In a statement, he added: “As this action illustrates, the Commission will hold investment advisers accountable when they do not accurately describe their incorporation of ESG factors into their investment selection process.”

At present, the SEC does not have rules in effect dictating what ESG investing means or requires. Therefore, enforcement actions like the one brought against BNY Mellon focus on an investment adviser’s promises to investors in a fund’s marketing and sales materials. If the actual investing practices materially deviate from what was advertised, it’s an invitation for the SEC to take action.

Numerous alternative frameworks have been developed to standardize the definition of “sustainability” in the context of ESG investing. A 2020 white paper on ESG regulation by the law firm Morgan Lewis notes that “popular ESG frameworks” include the Global Reporting Initiative, the Task Force on Climate Related Financial Disclosures, the Sustainability Accounting Standards Board, and the United Nations Sustainable Development Goals. However, the availability of various alternatives and absence of a single uniform, widely-accepted standard framework has contributed to a lack of clarity and consensus.

Without uniformity or consensus on what constitutes an ESG investment strategy or how environmental, social, and governance goals should be assessed and evaluated, the world of sustainable investing in the U.S. currently resembles the Wild West and greenwashing remains a significant concern.

Acknowledging that without “a common disclosure framework tailored to ESG investing” any fund or fund manager could exaggerate its ESG performance, the SEC has proposed a set of disclosure rules for investment advisers and investment companies.

Proposed SEC Rules for ESG Disclosures

In addition to the proposed rule to require publically traded companies to include climate related disclosures in registration statements and periodic reports, the SEC has proposed a pair of rule changes for investment funds and advisers to help address greenwashing, expanding the requirements for ESG disclosures for Funds and updating the Names Rule,

Under the proposed ESG Disclosures for Investment Advisers and Investment Companies requirements, the SEC aims to curb funds’ or advisers’ ability to exaggerate the focus of a portfolio that promises to incorporate ESG investing.

• Funds advertised as Integration Funds — which blend ESG factors with non-ESG factors in their investment formulas — will be required to show how both ESG and non-ESG factors are incorporated into their investment process.
• ESG-Focused Funds, for which ESG factors are a significant or main consideration, would be required to provide detailed disclosure, including a standardized ESG strategy overview table.
• Impact Funds are a subset of ESG-Focused Funds that seek to achieve a particular ESG impact. These funds would be required to disclose how they measure progress relative to the desired impact.

The proposal would also require that if funds use proxy voting or engagement with issuers as a significant means of implementing their ESG strategy, they provide information about their proxy voting or ESG engagement meetings. Additionally, funds which consider environmental factors would be required to disclose greenhouse gas emissions metrics on their investments as well as additional information about how the fund develops those metrics. Funds that disclose that they do not consider greenhouse gas emissions as part of their ESG strategy would not be required to report this information.

The SEC is also proposing the modification and expansion of its Names Rule to cover, among other investment strategies, ESG funds. Under the proposal, registered investment companies with names “indicating that the fund’s investment decisions incorporate ESG factors must invest at least 80 percent of their assets’ value in those investments.” A fund’s name, the Commission notes, “is an important marketing tool and can have a significant impact on investors’ decisions when selecting investments.” Failing to comply, the SEC proposal adds, “would be defined as materially deceptive or misleading.”

Evolving Market Reaction

The SEC’s proposed rules have been met with some resistance, with organizations questioning how to implement the requirements and pointing to the difficulty in measurement of certain emissions metrics. And although shareholder proposals on ESG issues have been on the rise, overall support has declined.

Europe has already embraced the need for ESG disclosures and has mandated climate disclosures for corporate entities through the Sustainable Finance Disclosure Regulation (SFDR) and more recently the Sustainable Finance Strategy. If reporting and disclosure requirements related to ESG investing are mandated for funds in the U.S., the result may be a higher degree of transparency, but along with increased costs associated with the additional reporting and measurement necessary for compliance – costs which negatively impact investment returns. This increased reporting could result in large numbers of funds losing their “sustainable” status, either as a result of prohibitive costs of compliance or failure to achieve quantitative metrics.

Other market reactions have been unrelated to the proposed regulations around ESG funds. Recently, there has been backlash against ESG investing philosophies and the influence large passively-managed funds hold on the market. Leaders in some states with economies that are heavily reliant on the oil and gas industry are pushing back against what they characterize as a harmful “trend”, arguing that ESG goals make little economic sense and have an adverse effect on their states’ economies and pension fund performance. State pensions have reportedly pulled more than $1.5 billion from funds because of these concerns. On the private-sector front, a similar anti-ESG sentiment is demonstrated by the actively-traded “Anti-ESG” funds that have recently launched and are quickly gaining assets under management.

Can today’s “sustainable” funds maintain their green cachet in the face of greater scrutiny and increased regulatory requirements? And will investors continue to put their money in ESG funds if economic factors in the U.S. and the world lead to recession? Funds and companies considering environmental, social, and governance commitments need to understand the nuanced challenges they may face.

Three Questions to Consider

If you are thinking about adding sustainable investment funds to your portfolio here are three questions to consider:

1. What is your goal for an Impact Investing strategy?
   First and foremost, understand that Impact Investing is a complicated proposition. In addition to market risk, managers undertaking this strategy should prepare themselves for potential changing regulatory and financial reporting requirements. In addition, managers should carefully determine the parameters for measuring success of the strategy and weigh these factors, as well as the potential reactions from investors, along with performance.
2. Have you defined your ESG philosophy?
   What issues will you address: Carbon emissions? Renewable energy or energy storage? Social impacts such as fair treatment of employees? Social and community-based investments? Managers should define — and refine — an investment philosophy as the foundation for its investment portfolio and the measurements that will be key to tracking success of its ESG goals.
3. How will you implement and monitor your Impact Investing strategy?
   Whether the investing is done in-house or by outside asset managers, managers should plan ahead. The available ESG data can vary widely, stakeholder approvals must be gained, allocation targets set, and firms must weigh public perception, personnel capabilities, and metrics of progress as part of the equation.

If you’re wondering how to assess your current state in this evolving sector, Weaver is here to help. Contact us for information on our ESG and related services.

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