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Impact investing heading towards passive investing in public markets

© Shutterstock / O_P_GAsset manager DWS logo.

Research from global asset manager DWS Group and research company Create suggests that impact investing is moving beyond the private markets towards the public markets, in a potential reimaging of capitalism.

A new report shows a growth of impact investing taking place in pension funds and public markets and gaining market traction.

Although only minor proportions of portfolios are currently embedded in impact investing, sentiment is growing for impact investing to form an increasing proportion of portfolios.

Impact ETFs are being launched by investment management firms and indexes are being developed, indicating financial markets could be on the cusp of a paradigm shift towards the integration of sustainability goals.

Public markets offer the scale and transparency required to transform the ratcheting up of commitments to net zero goals into publicly traded instruments. It is also necessary in terms of capital to attain net zero goals.

The report, led by Professor Amin Rajan and a team from DWS and XX Create,  was based on a survey of senior decision-makers at pension funds around the world, and reports that impact investing is becoming a growing theme for pension investment, especially among passive investment offerings.

It drew on the expertise and perspective of 50 large pension funds based in North America, Europe and Australasia, collectively managing €3.3 trillion of assets. Of the respondents, 64% think that the net zero goal will favour impact investing and 54% project a growth of investment around the SDGs.

Bonds are seen as the more likely asset class than equities for the achievement of sustainability goals as they are more transparent and ensure returns on both the financial and social front.

Is impact investing leading to a reimagination of capitalism?

The growing interest in impact investing is based on the belief that the world is at an inflection point but also that capital markets can and will duly price in environmental and social risks with a growing emphasis on a measurable double bottom line.

Investment required to reach the global net zero goal by 2050 is in the order of $100 trillion, beyond the scope of private investment alone. Public markets however have  leverage that could be used extensively towards sustainable development with passive investment linked to rule- based indices like the European Union’s Paris-Aligned & Climate Transition benchmarks.

Professor Amin Rajan wrote: “Reimagining capitalism is a new imperative – one that puts as much emphasis on human, social and natural capital as it does on financial capital.”

However, he adds that “while the direction of travel is clear, the exact path is fraught with challenges,” citing spiralling inflation and the energy crisis brought into being by Russia’s invasion of Ukraine.

Certainly the energy and consequent cost of living crisis have seen policymakers return to short-term policy solutions, such as a focus on fossil fuels. Political polarisation around the use of the ESG investment lens has also had an impact.

This has hit the ESG market and capital markets and diverted policy attention to the immediate twin goals of lower inflation and energy security. 

Pension plans drawn in by fiduciary duty and company requirements

For pension plans, fiduciary duty still exists – an obligation to exercise a duty of care by putting clients’ interests and needs above all else – and that means looking to the future and shouldering some responsibility for taking action on climate change.

As a result, interest in impact investing is gaining traction among pension plans, and moving up through the varying ranks of engagement.

At the bottom is lower investment in companies deemed to engage in socially undesirable activities. The second layer aims to pick winners and exclude laggards in the sustainability space in order to earn good risk-adjusted returns. The top layer posits an overt goal to generate positive, measurable, social and environmental impacts alongside good financial returns. 

Growth over time

From the survey of pension funds, 58% believe that rising interest in thematic funds will morph into impact investing over time, and 48% foresee a proliferation of passive funds focused on impact themes.

Only 10% have impact investing fully embedded in their active portfolios and 4% have impact investing fully embedded in their passive portfolios among survey respondents but there are high levels of it being on the agenda.

Net zero goals and mandatory reporting of ESG risks are main growth drivers though pure-play impact companies drive momentum too.

The large and growing number of companies and governments embracing the net zero goal is the primary driver followed closely by new regulation requiring mandatory reporting of ESG risks and improved prospects for achieving a double bottom line.

In regards to impact investing in public markets they are in order of precedence; enhanced engagement activities, growth in companies transitioning from being climate laggards to climate leaders and enhanced standards for assessing intentionality, additionality and measurability. Furthermore pure-play best-in-class impact companies who are recognised as leaders in environmental or social solutions provide attractive investment targets.

Passive investment right vehicle for impact investing

Pension fund respondents see a greater increase in impact investing in public markets for a number of reasons:

1) that the transition is seeing climate laggards becoming climate leaders and are reducing their cost of capital by satisfying some of the stringent criteria that come with impact investing;

2)the rise of impact solutions providers in public markets means that the cost of impact investing is a lot lower compared with private markets;

3) it is much better analysed and understood than private company investing, which does not have a comparable track record in meeting goals and metrics;

4) public companies have the scale and reach to create the intended impacts in multiple jurisdictions. 

Bonds – green, social or sustainability – have seen a huge rise in issuance. They are transparent in that their impact credentials are usually certified by independent external reviewers.

Their proceeds are solely committed to impact-type projects and offer a basis for engagement normally reserved for equity holders, says Rajan. In contrast, this requirement does not apply to general-purpose debt issued by a company, government or municipality. 

Impact investing follows UN SDGs

A key finding of the survey is that impact investing tends to follow the UN’s Sustainable Development Goals far more than the conventional ESG categorisation. The SDI Asset Owner Platform has recently tightened the granularity of the process by updating its classification of sustainable development investments (SDIs) to reflect negative impact on the UN Sustainable Development Goals (SDGs).

Rajan makes the point that ESG investing enjoins index managers to be active stewards of capital, since they are also forced owners of shares they hold. “Unlike active managers, they cannot dump their positions in poorly performing companies. With the price of index funds falling over the past three years, stewardship has become a key differentiator in the index world.

CREATE-Research is an independent research boutique specialising in strategic change in global investment management. 

DWS Group (DWS) is a world leading asset manager with € 833bn of assets under management. It has more than  60 years of experience.

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