A Brief History of Impact Investing: From Exclusions to Dynamic Customized Indexing
Over the last few decades, socially responsible investing has taken off, driven by investors who are eager to put their money to work with purpose. In 2016, sustainable, responsible and impact investments in the U.S. climbed over $8.7 trillion, up from about $3 trillion in 2010 and $500 billion in 1995, according to a report from the U.S. Forum for Sustainable and Responsible Investment. Leading asset managers have launched impact investing units, while governments have formed new policy initiatives supporting it. President Barack Obama’s National Impact Initiative, an effort to expand the government’s use of impact investing, for example, was the first time the U.S. government specifically invested in social enterprises.
Investors are increasingly keen to address the world’s most pressing economic, ecological and social challenges. But impact investing isn’t just the latest fad. It has a long and rich history that can be traced back to at least the 1700s, when early adopters of socially responsible investing were religiously motivated. It’s grown into a broad industry which includes Socially Responsible Investing, ESG Investing, and Thematic Investing — all of which coexist and are combined in various ways.
Excluding ‘sin’ stocks
The term “impact investing” wasn’t coined until 2007 by The Rockefeller Foundation. Yet that’s essentially what the Methodists were doing in the 1700s. In a well-known sermon, founder of Methodism John Wesley told congregants to “Gain all you can without hurting either yourself or your neighbor, in soul or body…” In the 1800s, the Quakers forbid members from investing in slavery. Islam has also integrated ethics into investing for centuries. A driving principle is that money should be used to create social value, not just wealth. The Quran, like many other religious texts, forbids investments in companies that engage in lending, gambling or producing alcohol, tobacco, weapons or pornography.
Investing for change
Over time, the approach to investing with impact has evolved, and investors pushing for social change began to exert pressure on companies to modify their business practices –or in some cases, the geographies in which they operated. One of the first instances occurred when socially-motivated investors divested from companies with operations in South Africa in an effort to show solidarity with those oppressed by apartheid. It began in the early 1980s, when students on U.S. college campuses demanded their universities stop investing in companies that conducted business in South Africa. Churches, universities, cities, and states followed suit. By the end of the decade, about 150 educational institutions had divested. As the movement gained traction, the U.S. government enacted sanctions against South Africa. The country’s deteriorating economic status, plus in-country resistance efforts, eventually led to the collapse of apartheid.
Seeking out positive deviance
More recently, the term ESG–Environmental, Social and Governance investing– has been used interchangeably with socially responsible investing (SRI). Investors using an ESG lens examine a company’s environmental and social business practices as well as its financials. Examples include how a company is affecting climate change, or the diversity of its board. Investors address ESG issues through thematic investing, or by investing specifically into solutions like renewable energy or water management. They often believe such investments will produce an improved risk-return profile.
Personalized impact investing
Since the 1700s, the impetus behind impact investing has remained the same– investors understand that their assets are also a force for social change. Increasingly, impact investing is shifting from a strategy adopted by a few to one open to a wider swath of investors. Today’s investors also want strategies that reflect their unique set of beliefs. They want approaches that are dynamic and can quickly shift with our rapidly evolving world. But they are attentive to costs as they seek to preserve their returns. This has led many to passive investing, which Morningstar has found beat active investing over the last decade.
In parallel, evolutions in technology have made impact investing accessible in a new way. The investment industry is shifting towards a post-fund paradigm, where direct indexing can account for personal values alongside tax management and streamlined fees. These Dynamic Custom Indices (DCIs) are democratizing access to bespoke investing strategies, to the benefit of investors concerned with both returns and impact.
As software begins to replace ETFs and Mutual Funds, the rationale for “one-size-fits-all” investment products for clients disappears. This opens the door to a wave of changes that are transforming values-based investing: reductions in trading costs remove the need for fund wrap fees. A shift to stock-level investing provides transparency into underlying holdings. Passive investing approaches neuter the doubts around investment performance of ESG strategies. And every institution and individual investor can expect a bespoke investment strategy without having to buy into the fund manager’s ethical framework. We’ve covered this transformation– which some have called “the great unwrapping”– in detail elsewhere, but in short, truly personalized impact investing is already here.
Many in the industry refer to the current period as the Golden Age of ESG, due to increasing demand and awareness across the U.S. market and beyond. Technology and DCIs will play a key role in empowering financial advisors, institutions, and individuals to accelerate this revolution. Incorporating unique investor values into portfolios will soon be as foundational to investing as optimizing for risk and return.