Impact investing: challenges and opportunities

ESG integration at EB-SIM

Mr. Höck, you have been Head of ESG Integration at EB-SIM since 2020. What exactly does this position involve?

ESG integration is understood to be the explicit and systematic inclusion of ESG aspects in investment decisions. The range of tasks in this area is indeed highly varied and it can differ greatly depending on the institutional setup and organizational structure.

One field of activity of growing importance is certainly compliance with regulatory requirements such as MiFID II or the Disclosure Regulation. But the further development and optimization of investment processes also play an important role. This can include, for example, the selection of suitable data providers, including an analysis of their respective strengths and weaknesses.

But the position is also fundamentally about observing developments in the field of sustainable finance and seeing where market standards are heading. My job is to ensure that we remain a pioneer in sustainable finance and integrate sustainability into investment strategies as holistically as possible.

Another activity that falls within my area of responsibility is maintaining our research and teaching cooperations with the universities of Kassel, Hamburg and Gießen. For example, we supervise master’s seminars on the topics of sustainable finance and impact investing. Linking research and practice has proven beneficial for us. The exchange with students often gives us new input and enables us to make contact with talents at an early stage. In addition, our research projects allow us to continuously develop our products and processes and align them with the state of the science.

Difference between ESG investing and impact investing

We would like to talk about impact investing today. What is the difference between ESG investing and impact investing and to what extent are the two topics related?

First of all, in sustainable finance, a distinction can be made between three sustainability dimensions: value orientation, integration, and impact orientation.

• Value orientation is primarily about exclusion criteria. Companies that don’t comply with a previously defined set of values are excluded. As a matter of principle, no investments will then made in the arms industry, for example, or in government bonds from countries where the death penalty still exists.
• The second sustainability dimension, integration, represents the next development stage. Instead of being limited to exclusion criteria, sustainability indicators are actively included in company evaluation and portfolio construction.
• In the third sustainability dimension, impact orientation, clear sustainability goals that are to be achieved with the investment must be identifiable.

In impact orientation, a further distinction is made between investments that are impact-aligned and those that are impact-generating. An investment is impact-aligned if it is clearly aligned with sustainability goals and makes a significant, but not directly measurable, contribution to meeting those goals. Investments are impact-generating if they make an active and measurable contribution to the achievement of goals.

Only those investment strategies that not only meet the requirements of the first and second sustainability dimension, but also have an impact orientation, constitute true impact investing. In contrast, investments that only meet the requirements of the first or second sustainability dimension are also referred to as ESG-screened or ESG-managed investments.

Private equity and venture capital funds can directly influence the companies they invest in. In public equity, the portfolio company benefits from my investment, but strictly speaking only in the IPO and in capital increases. If I buy shares in an already listed company and sell my shares before the next capital increase, have I had any impact on the company at all?

Well, this is where the distinction between “impact-aligned” and “impact-generating” plays an important role. Strategies for investing in liquid asset classes (shares, bonds, etc.) can hardly meet the criterion of impact generation, but they can certainly be impact-aligned.

Although investors in liquid asset classes do not have a direct influence on the real economy, they still have an influence on the company. A major impact can be achieved first of all through capital allocation. Targeted investments in green companies and those seeking to become more sustainable by undergoing a transformation process allow these companies to raise capital more cheaply than their competitors can. So that is a competitive advantage.

But even at times when a company is not raising new capital, it is still possible to exert influence. Active ownership strategies play an important role here. These include, for example, actively exercising voting rights, but also engagement approaches in which you enter into a dialog with a company and support it in its transformation towards a more sustainable business model.

Ultimately, however, impact fund investments also have a signaling effect. If fund managers of sustainable investment products avoid a company, this can lead to awkward questions for the board of directors. By contrast, if a company is popular with sustainable funds, this can also be used for marketing purposes.

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Impact investing with active ownership

You mentioned active ownership and voting rights. How can small asset management firms effectively use their voting rights for impact investing? Isn’t it quite a challenge to determine what should be voted for to promote sustainability?

For this issue, cooperating with specialized and qualified service providers for proxy voting is a good solution. The service provider submits proposals in accordance with an ESG policy defined in advance. The asset manager mostly follows these but may also vote contrary to the recommendation. This is an efficient way to exercise voting rights while taking sustainability aspects into account and to encourage companies in their sustainable transformation.

Greenwashing and impact washing

In the Disclosure Regulation, which has been in force since March 2021, the EU stipulates that financial market participants must disclose how sustainable both they themselves and their products are. The Regulation distinguishes between conventional fund products (Article 6), funds that take social and sustainable aspects into account in their investment decisions (Article 8), and those that have a sustainable investment objective and contribute to ensuring that the UN Sustainable Development Goals (SDGs) are not violated (Article 9). So do the latter ones fall under impact investing?

No, Article 9 products frequently aren’t impact funds, even though clients are often led to believe so. This applies in particular to ETFs covered by Article 9 of the Disclosure Regulation. It is very difficult to engage in actual impact investing with a passive investment strategy, which is rules-based by definition.

Not violating the Sustainable Development Goals and making its sustainability goals transparent is only the necessary condition, but by itself it is not sufficient for classification as a true impact fund. The strategy must also have a positive impact through active ownership. However, this is not the case with some Article 9 funds.

When you say that Article 9 funds are often sold to clients as impact funds even though, strictly speaking, they do not pursue impact investing strategies, this brings us to the much-cited problem of greenwashing or impact washing. How can clients tell a good impact fund from a bad one?

Greenwashing remains a major challenge. The first problem arises when it comes to communicating the various sustainability approaches to the client in the first place. Under the Disclosure Regulation, an Article 9 fund is only required to demonstrate a sustainability goal and meet strict disclosure requirements. Therefore, there are also significant differences between these funds in terms of sustainability ambitions.

One cornerstone that serves as guidance for investors is the institutional credibility of the asset manager. Has the asset manager only recently jumped on the bandwagon or have ESG criteria been part of its DNA for years? How transparent is the provider regarding its sustainability characteristics at the product level? What is the asset manager’s approach to active ownership? Are processes explained in a comprehensible way or is it just superficial statements? These are all questions that investors should ask themselves.

ESG ratings

In the field of ESG, poor data quality is often criticized. In some cases, there is a lack of sufficient information to generate qualified ESG ratings. Rating agencies sometimes contradict each other in their assessments. Isn’t this problem even greater in impact investing? How can this issue be mitigated?

The problem of poor data quality is certainly no smaller in impact investing. There are nearly sixty sustainability rating agencies on the market, with the largest based in Anglo-American regions. These providers differ considerably – even in terms of their opinion of what should be measured in the first place. Definitions and ambitions vary widely in this area. And there are also differences in how sustainability is measured and which indicators are used to evaluate it.

It is important to first collect and validate your own data requirements. Different data is needed for the different steps in the investment process. Only when you have specified your own ambitions and it is clear what you need to look out for to also meet regulatory requirements should you ask for offers from various providers. It is essential to understand the product in detail and to talk to the providers to get the full picture. Weaknesses in data quality are primarily a problem when you are not aware of them. If the weaknesses of your data are known, the resulting risks can often be mitigated.

Of course, the high costs of data providers are also a challenge in a market environment where fee pressure is increasing.

One point of criticism with regard to sustainable investment products and impact investing is the additional costs you mentioned, which are associated with the increased data requirements, for example. The mounting financial burdens, combined with a restricted investment universe in which certain sectors and industries are overweight or underweight, pose challenges for portfolio management. Does the consideration of sustainability aspects and social justice in the investment process come at the cost of returns?

Of course, sustainability criteria have an influence on the scope of the investment universe. One of our tasks is to look at how sustainable investment strategies can still be operationalized when also taking the risk management and portfolio construction perspectives into account. However, it is definitely possible to continue to create well-diversified portfolios.

When considering risk-adjusted returns, i.e. when the expected returns are put in relation to the risk taken, there should be no performance differences between sustainability funds and traditional funds. But even in terms of absolute performance, sustainable fund products are not inevitably linked to poorer results. A historical comparison of performance shows that sustainable investment products do not perform worse than other products. Depending on the period considered, sustainable investment strategies may even perform better.

However, the choice of a suitable benchmark is also important in this context. It should be clarified whether the product has the ambition to keep up with traditional benchmarks. For some impact products, which hardly take any sustainability risks, classic benchmarks are not adequate. In general, it is a good idea to move away from this benchmark fixation a bit. While climate benchmarks exist, they are not necessarily appropriate for social or broader environmental impact funds.

The “S” and the “G” in “ESG

Benchmarks for environmental sustainability already exist, but not yet for social justice. Is the environmental aspect the most important one in ESG and impact investing?

It is true that, in general, environmental aspects are often given priority. Of course, this has to do with the fact that the focus of the social debate is on climate change and, increasingly, on biodiversity.

This is not just a subjective impression. A currently unpublished study by researchers, from the University of Gießen among others, shows that U.S. companies have been able to increase their environmental and business ethical sustainability over the past decade, while the social component has fallen behind. Companies have to allocate their resources between the different sustainability components – environmental, social and governance – and obviously do not consider all dimensions to the same extent.

However, the focus on sustainability is also influenced by the regulatory framework, which has so far been largely geared to environmental goals. Up to now, social aspects have played a lesser role at the regulatory level. The “S” and the “G” in “ESG” must therefore move more center stage in the future to enable a socially just sustainability transformation.