Portfolio construction: the third dimension

16 August 2021

Money & Life team

Money & Life contributors draw on their diverse range of experience to present you with insights and guidance that will help you manage your financial wellbeing, achieve your lifestyle goals and plan for your financial future.

Investors are increasingly looking for strategies that go beyond traditional ESG investing principles, by seeking to use their capital to contribute to solutions that make a lasting difference to society and the environment, without compromising their financial returns. Jayson Forrest reports.

Name: Trevor Thomas CFP®

Position: Managing Director

Practice: Ethinvest

Licensee: Ethinvest

Years as a financial planner: 24 years


Name: Farren Williams CFP®

Position: Adviser and Partner

Practice: Koda Capital

Licensee: Koda Capital

Years as a financial planner: 20 years


Name: Leah Willis

Position: Head of Client Relationships

Company: Australian Ethical Investment


With the rise in awareness of ethical and responsible investing, it’s hardly surprising that more Australians now expect their savings (87 per cent) and superannuation (86 per cent) to be invested responsibly and ethically. But what these figures from the Responsible Investment Association Australasia (RIAA) conceal is the increasing demand by investors for investment opportunities that go the next step, by taking their investing beyond traditional environmental, social and governance (ESG) principles.

These investors are seeking to use their capital to invest in solutions that make a genuine impact, with many turning to impact investing – a style of investing where the core investments seek to make a lasting difference to society and the environment without compromising financial returns – to achieve this.

According to the Global Impact Investing Network (GIIN) – a worldwide movement aimed at increasing the awareness of impact investing – impact investing takes the concept of responsible investing to the next level, where capital is invested with organisations, projects or funds that are generating measurable, positive social and environment outcomes, alongside a financial return.

Today, impact investing can be seen in a range of sectors: from sustainable agriculture, renewable energy, conservation, and microfinance, to affordable and accessible basic services, like housing, healthcare, and education.

“Impact investing involves having a clear set of goals you want to achieve with intent,” says Ethinvest Managing Director, Trevor Thomas CFP®. “You set out the intent in terms of the environmental and/or social impact, and then you track your performance against that intent. You are looking to make sure your money is achieving measurable outcomes beyond just financial returns.”

Clients that want to do good

The type of client attracted to impact investing is wide and varied, ranging from public and private foundations, to family offices, institutional investors, governments, fund managers, community finance organisations, right through to individual retail investors.

“This style of investing appeals to a wide range of client types,” says Farren Williams CFP® – an Adviser and Partner at Koda Capital. “For private clients, they often want to know that their portfolio is contributing to real world outcomes and this also helps them have a stronger connection to their investments. They want to invest in businesses and projects that are moving the dial in areas they are passionate about. 

“Incorporating impact investments in their portfolio, enables clients to amplify the impact they can make through their investment portfolio, while delivering a financial return that meets their objectives.”

Trevor adds the philanthropic sector has been the real driver of impact investing over the last 10-15 years, with these investors – such as charitable organisations and foundations – seeking to invest their capital in investments that are aligned to their philanthropic vision. 

According to Leah Willis – Head of Client Relationships at Australian Ethical – there is a common misconception within the market that responsible investing that delivers impact is only attractive to Millennials and younger investors. Instead, she points to recent syndicated research from Investment Trends about consumer attitudes to ESG and responsible investing, which found a strong demand for this style of investing across all age groups.

“Investors are drawn to responsible investing because they want to make a beneficial impact in the way they invest. Their motivation to invest this way is varied, including: wanting to create a better future for their children and/or grandchildren; concern about the effects of climate change; and not wanting their investments to fund activities or practices they weren’t comfortable with.”

Another misconception Leah identifies is the belief that investors have to make concessions on their portfolio returns in order to make a positive social and environmental contribution. She refers to numerous industry studies, including from RIAA, confirming that responsible investing can generate returns at least as good, if not better, as a traditional portfolio.

“You absolutely don’t need to sacrifice investment returns to achieve impact,” says Leah. “Like all investments, there are good ones and bad ones in the market. Therefore, it’s always important for planners to be aware of what they are investing in.”

A philosophy to investing

Fundamental to its approach to responsible investing, Australian Ethical uses an Ethical Charter, which underpins the way in which the organisation generates impact through its investment process. This Charter has 23 principles which are used to screen investments.

In fact, Australian Ethical takes the view that capital is one of the strongest ways investors can make an impact on critical social and environmental issues.

“Investors can use their capital as a force for good, by directing it towards more positive investments and businesses that are actually helping to support a more sustainable future and better social and environmental outcomes,” says Leah.

“Our investment philosophy is about removing the social licence of those companies we think are unethical or are producing products or services that are directly harmful to the environment or society. We do that by including positive, sustainable and forward-looking investments, while excluding those investments that we deem to be negative.”

Australian Ethical excludes almost 60 per cent of the ASX Top 100 companies from investment selection. These companies fail to meet its strict investment criteria, either due to the products or services they produce or the way in which they are run.

By excluding 60 per cent of the top stocks, Leah says it’s a great opportunity for the business to apply its deep investment expertise to produce alpha, while searching for opportunities in the mid, small and micro cap sectors that other managers might not be looking for.

“We end up in sectors like healthcare, IT and utilities, where we get some terrific renewables exposure. It’s a very different looking portfolio than your mainstream Aussie equity large cap portfolio,” says Leah.

No compromise on returns

Farren believes for impact investing to be successfully integrated in a client’s portfolio, planners need to take the time to fully understand their clients’ values and investment preferences, including what activities they want to promote and avoid and what solutions they want to contribute to. From there, a portfolio can be constructed to maximise the impact clients can achieve with their money.

“At Koda Capital, our approach to investing for a social and/or environmental impact, along with financial returns, begins with understanding each client’s values and passions, their risk tolerance, and what their return requirements are. Understanding these factors will drive the sorts of impact investments that resonate and are appropriate for each client,” says Farren.

“We don’t see impact investing as having to compromise on financial returns or risk. We conduct a deep dive on the impact thesis, including how the impact is created, how it is measured, whether it is likely to be enduring and whether there are any perverse outcomes, as well as analysing the financial drivers and risks, just as you would do with any investment.”

It’s a similar approach at Ethinvest, where Trevor says investors can find impact investment opportunities across the whole spectrum of asset classes – from social impact bonds, to private equity and venture capital, listed equities, real assets, through to property and mortgaged-backed lending against property.

And while Ethinvest seeks to invest its clients’ capital in investments that are aligned to making a positive environmental and social contribution, in instances where there are specific corporate practises or policies a client wants to change, it might also buy shares in a company and undertake shareholder activism to try and change the company’s perspective on particular issues, like fossil fuels.

It’s a similar position undertaken at Australian Ethical, with Leah confirming that shareholder engagement is also a core part of its ethical process, where it works alongside advocacy groups, like Market Forces, to try and influence corporate change among Australian companies.

Putting impact into practice   

To help Ethinvest take the next step from ethical and responsible investing to impact investing, it made a significant decision to set up a new company – Australian Impact Investments – that specialises in impact investing.

“At the time, we couldn’t find much information in the marketplace that would allow us to properly assess all the impact investing opportunities that clients were wanting. So, we decided that the best way forward was to set up Australian Impact Investments,” says Trevor.

Australian Impact Investments was formed six years ago and operates independently from Ethinvest. It is a specialist consulting firm that provides advice to clients seeking to mobilise their capital to create positive environmental and social impact alongside financial returns.

Ethinvest uses Australian Impact Investments to assess various impact investment opportunities. The investments that pass the screening process are then presented to clients whose specific investment profile matches the impact opportunity.

Recent impact investment opportunities screened by Australian Impact Investments have fallen into a range of sectors, including: public transport; solar farms; regenerative agriculture; remote area power generation; and Indigenous education.

For Farren, the key to developing a strategy that puts impact into practice begins with ensuring the portfolio construction principles around asset allocation and diversification are securely in place.

“It’s not a matter of having a balanced portfolio and then adding responsible investments as accessories. Instead, it’s all about working out what asset allocation is appropriate for the client, and then within each asset class, finding investments that provide the client with the right financial outcome, ethical alignment and, where possible, positive impact,” she says.

Farren points to a range of impact opportunities, including: special disability housing; renewable energy infrastructure; venture capital targeting scaleable impact often with a gender lens; social impact bonds; and agricultural businesses involved in improving soil health, enhancing ecosystems and using scarce resources more efficiently. The opportunity set is wide and varied and can be accessed through direct investments, as well as managed funds, but rigorous due diligence is required.

Consider the impact thesis

When it comes to impact investing, there are a lot of good ideas in the market, but not all of them stack up commercially. Therefore, Trevor believes that for investors wanting to combine both financial returns, along with tangible social and environmental impacts, they first need to consider the financial analysis of the deal and the impact thesis of the investment.

He explains: “One of the challenges of impact investing is to make sure there is a solid business model and a strong financial case underpinning the investment, to ensure you are getting an appropriate return for the risk that you’re taking. Or if it’s about getting a concessional return, then it’s because you want to.”

And then there’s the impact thesis. This means determining if the impact theory is strong. Will it achieve its goals? What are the risks? How committed is the business to the impact?

Farren also warns that as impact investing gains momentum, there is a risk of investments being mislabelled or ‘impact washed’ by companies and funds, in order to attract capital. ‘Impact washing’ is a form of marketing spin where companies or fund managers deceptively make impact-focused claims without having a demonstrable positive social or environmental impact.

“It’s critical that planners undertake a deep dive analysis of these products, in order to identify the investments that will genuinely deliver impact, while also providing a suitable return,” Farren says. 

“When undertaking your due diligence, you need to closely consider the quality and capability of the people behind the investment, what the impact thesis is, and make sure the investment returns align with the impact. That’s because you want to ensure that the the impact and return are aligned and moving in lockstep, rather than being in tension with each other.”  

Tips and traps

Investing to achieve social and environmental impact might sound attractive, but impact investing is not suited to every business or client. However, for those advice practices considering going down the impact investing path, there are five key points to keep in mind.

1. Do your research

Implementing an investing strategy that achieves measurable impact and financial return can be confusing and complex for planners. Impact investing is a relatively new area for planners, meaning many practitioners lack the knowledge and confidence to lead conversations with clients on this style of investing.

However, there is an ever-increasing range of materials and resources available for planners in this investing space, including from RIAA, GIIN, and Australian Impact Investments. There are also a number of fund managers that also offer a range of resources.

2. Find investments that are open

It can be challenging for planners to find a diversified range of impact investments that are open. That’s because most of these funds tend to be wholesale (although this is changing) and are only open for a set period, rather than being open-ended funds.

“Therefore, you have to take a fund while it’s open, which means it can take time to build up a complete portfolio,” says Trevor. “Instead, it’s often easier to find impact opportunities in the venture capital or private equity space, compared to other asset classes. This means while you may quickly fill up your allocation to private equity, it might take you longer to find credit and income-focused investments in the defensive space.”

3. Know your client

Take the time to properly understand your clients, their risk appetite, their values and preferences, and the issues they are interested in. By doing so, planners are better able to identify the impact areas that resonate with clients, as well as the asset classes they need to be looking for opportunities in.

4. Don’t be afraid to say ‘no’

There are many investment opportunities in the responsible and impact space, so don’t be afraid to reject investments that don’t meet your criteria. Farren says it’s much better for planners to take their time and find a few high quality investments that meet the return, risk and impact requirements they are looking for.

Leah adds that practitioners need to be mindful that many of these impact investment opportunities have grown out of private equity and venture capital businesses. As a result, they are often less liquid, which might mean allocating a smaller proportion of an investor’s overall portfolio to these opportunities if liquidity is an issue.

5. Specialist organisations

Specialist organisations, like RIAA and GIIN, can help improve a business’s understanding of responsible and impact investing, while introducing it to other professionals and practices already working in this space.

Don’t reinvent the wheel

There’s no doubt that responsible investing that provides measurable and beneficial social and environmental impacts is currently very popular with investors. And while this style of investing is relatively new for many practitioners, Leah advises any advice business considering going down the impact investing path to not be overwhelmed by it.

“Don’t throw the old out with the new,” says Leah. “Achieving impact through responsible investing doesn’t require you to reinvent your models or reinvent traditional risk-return portfolio construction. It’s simply a third dimension to portfolio construction.

“As financial planners, the more we think about investments and the potential causes of harm they can do in a portfolio from a social and environmental perspective, the greater the potential positive contribution an investor can make to social and environmental solutions. Impact investing is simply an evolution of modern portfolio construction.” 

Shades of green: explaining the jargon

Environmental, Social and Governance (ESG)Three broad categories, where investors consider it important to incorporate their values and concerns into their selection of investments, instead of simply considering the potential profitability and/or risk presented by an investment opportunity.

Responsible investing – An umbrella term used to cover a broad-based approach to investing which factors in people, society and the environment, along with financial performance, when making and managing investments.

Ethical – Investment decision-making based on values that avoids harmful investments, like weapons, and includes positive investments, like healthcare, to positively impact the broader world, while still delivering financial returns.

Impact investing – Investments made with the intention to generate positive, measurable social and environmental impact, alongside a financial return. For example, Sally’s $20,000 investment has treated 200,000 litres of waste water, and generated 36MWH of renewable energy, while returning her X per cent for the last 12 months.

Engagement – Advocacy and engagement with companies to influence corporate behaviour and decision-making.