Asset owners that care about impact have a problem: “impact washing.” Impact washing in investing is when an asset manager misrepresents the non-financial benefits of its investment strategy. It goes well beyond funds misrepresenting their holdings or processes, and asset owners with objectives to have a positive impact need to be savvy to spot impact washing to avoid it. Here’s our take on four telltale signs that an asset manager is likely to be impact washing.
Confusing ESG integration and impact investing
These approaches have different objectives, though both fall under the umbrella of responsible investing. ESG integration is about using analysis of material ESG risks and opportunities to pursue the objective of improving long-term risk adjusted returns, whereas impact investing has the objective of generating positive real-world environmental or social impacts beyond risk and return.
As an example, an asset manager using ESG integration might anticipate a change to environmental regulations and select which securities or assets they believe will be most profitable from this change. This approach is acceptable by most fiduciary standards because it is focused on improving financial performance. While it may result in a portfolio tilted toward more sustainable companies, it doesn’t have to.
Investment managers formally claiming in their offering documents or reporting to focus only on ESG integration might claim positive social and environmental benefits; this may include reporting how investments are contributing to the UN Sustainable Development Goals. Conflating ESG integration and impact can be impact washing by exaggerating non-financial benefits from ESG integration, where non-financial impacts are not an objective, and at best, an unintended byproduct.
Not acknowledging there are tradeoffs between impact and returns
We frequently hear proponents of impact investing say that investors do not need to accept tradeoffs between impact and expected risk or returns. We do not agree. If impact investing did not require any tradeoffs relative to conventional investing, then the portfolios of impact and conventional investors would be identical. Pursuing impact investing almost always results in portfolio changes, and thus there must be a tradeoff with investment characteristics such as risk, expected return, liquidity, or fees from adding the impact objective.
This doesn’t mean that investments with attractive prospects for returns cannot have impact, but that the assets with the best return prospects don’t necessarily have the highest impact.
Impact investors must find a balance between seeking returns and impact. Not acknowledging tradeoffs between returns and impact doesn’t mean that such tradeoffs don’t exist. Rather, it means that investors are less aware and intentional about the impact of their decisions, which can result in impact washing.
Drawing no distinction between the impact of the investor and the underlying investments
An unsophisticated impact investor might take the approach of identifying companies having a positive impact, then investing in those companies. There is a missing piece in the logic chain: Did the investor cause the company’s impact to increase, or would the company’s impact have occurred regardless?
An investor’s impact is the way it changes the actions of the enterprises in which it invests. For example, if you invest in a pharmaceutical company, your impact is not simply the share of the lives saved by the company in proportion to your fractional ownership of the company, but rather, your impact is how many more lives the company saved because of your investment.
This is not a universally embraced concept in the world of impact investing, as it is almost impossible to observe the impact for most investments, yet considering impact in this way still provides useful insights. Ignoring the distinction between the impact of the investor and the underlying investments is a sign of impact washing by overstating the investor’s impact.
Heavy reliance on faulty metrics to measure and communicate impact
Accurately measuring impact is challenging, and a flawed approach is common: heavy reliance on faulty metrics with no acknowledgement of their limitations and nascency.
One example is carbon measurement, which analyzes the carbon dioxide emissions equivalents coming from the companies underlying a portfolio. There is not a strong connection between decarbonizing a portfolio and decarbonizing the real economy. That is, an investor can divest from securities that emit high carbon emissions, but that doesn’t mean the divested securities will emit less.
Another example is issuer-level and aggregated ESG ratings, which are designed to measure the exposures of securities to certain ESG factors. Importantly, ESG ratings are typically not even intended to measure the impact of the investor. ESG ratings provide virtually no information about the investor’s impact.
While these two types of measurements can be useful for some objectives, naively using them to assess impact without acknowledging their flaws can lead to impact washing.
What asset allocators need to know
Impact washing could severely undermine the credibility of the impact investing industry just at a time when demand is growing, particularly from nonprofits. To achieve true impact, it is important for asset allocators with impact investment goals to carefully evaluate the claims of asset managers.
Eric Friedman is on Aon Investments’ Investment Policy Services team, based in Chicago. Daniel Ingram is Aon Investments’ North American head of responsible investments, based in Los Angeles. This content represents the views of the authors. It was submitted and edited under Pensions & Investments guidelines but is not a product of P&I’s editorial team.
