Andrew Lo: It is possible to measure the impact of impact investing

For investors and managers wishing to align the ethical and fiduciary objectives of their portfolios, the costs and benefits of impact investing are often difficult to quantify. In a recently published research paper, however, authors Andrew Lo, professor of finance at the Massachusetts Institute of Technology, and Ruixun Zhang, affiliate researcher at MIT Laboratory for Financial Engineering and assistant professor at Peking University, proposed a framework. that managers and allocators can use to determine the actual financial effect that an impact investment has on their portfolio. Impact is any type of investment that has objectives beyond financial performance, such as socially responsible investment (SRI), environmental, social and corporate governance (ESG) mandates, or any other non-financial investment criterion that takes into account social priorities and agendas.

The framework considers the correlation between the impact factor (i.e. the limits that determine which securities can and cannot be included in the portfolio) and the performance of those securities on an individual basis. Historically, investors have simply viewed impact investing as an extension of standard portfolio selection, but with additional constraints. This assumption, they say, implies that impact investments have a “no superior risk / reward profile” – in other words, that they perform less well than investments that do not come with impact mandates. .

“As a general rule of thumb when teaching impact investing, the line given by academics in finance is that ‘if you limit your universe to a subset of stocks, you are clearly going to put the client at a disadvantage,” he said. declared Lo. Institutional investor.

But this assumption is not always correct, argue the authors. It is based on the idea that the constraint (i.e. the impact mandate) is statistically independent of the returns. What they found is that sometimes it’s true, but sometimes it’s not – and it depends on whether or not the impact criteria have a real relationship with the performance characteristics of the teams. portfolio securities.

“Imagine if the subset of securities that you are going to coerce your investor into happens to be the securities that Warren Buffett is going to invest in over the next three years,” Lo explained. “Now let’s not debate whether we can access this information, but I think we can all agree that [that] sounds like a pretty good idea. So clearly, limiting your investments to a subset [is not by itself] sufficient to guarantee [that] you are going to make things worse for investors. As another example, Lo said to try to imagine a scenario in which a portfolio manager would limit himself to investing only in securities beginning with the letter “Q”. Obviously, because this constraint has nothing to do with the performance or poor performance of these stocks, its use would not necessarily help or harm investors in this portfolio.

And that’s exactly what the two men discovered: that impact investing can have both positive and negative impacts on a portfolio’s risk-return profiles, and that it’s the right selection of individual securities in a portfolio that matters, not the constraints imposed on the portfolio. Armed with this information, the authors realized that investors and managers needed a way to quantify this effect.

“This is what we do in our framework,” Lo said. “The idea is to take different types of impact[s] and put them on the same footing. We have developed a quantitative framework to illustrate [that it’s the] correlations between the selection methodology and the ultimate performance of the security [that] determines whether or not the impact investment is going to have a positive or negative impact. And we show how you can actually measure it, and then once you measure it, we show how you can leverage it or disclose it to investors. ”

The paper uses the Cystic Fibrosis Foundation as an example of how this performance method can be mutually beneficial for managers, investors and stakeholders. Over the past 12 years, the CF Foundation has invested $ 150 million in a Boston-based biotech company called Vertex Pharmaceuticals, in hopes that Vertex could develop a drug that would minimize the effects of cystic fibrosis. This campaign resulted in the development of a drug called Kalydeco, which minimizes the underlying causes of cystic fibrosis. In 2014, the foundation sold its development royalties for $ 3.3 billion, a huge return.

“This is an example of a very, very profitable impact investing,” Lo said. “Keep in mind that the CF Foundation doesn’t give a damn about monetary return. Their goal was to develop a drug. Because of their focus, this is what allowed them to be successful. Lo said that the history of the CF is a good example of a causal relationship: the impact could not have happened without the return, and the return could not have happened without the impact.

Lo and Zhang’s framework can be applied to institutional portfolios in three different ways, Lo said. First, the framework will open a dialogue between investors and portfolio managers on the specifics of their impact investments. “It is a framework for fulfilling fiduciary responsibilities,” Lo said.

Second, the framework gives portfolio managers a way to maximize their impact. Depending on the results, once the correlation is measured, managers can use standard portfolio theory methodology to build a “super efficient” portfolio, Lo said.

The third application of the framework is performance attribution. Once a manager has made the investments and disclosed the projected performance to the allocator, the executive can calculate the actual performance. “Again, you can communicate to your investors whether or not you have achieved the impact [that] you said you would, and if the cost to investors was what you were, ”Lo said.