The Wealth Management evolution: Investing with purpose and impact part three

Part III: Moving forward: what it takes by Carina Schaurte
Now it’s time to bring it all together. After looking at the existing market and underlying concepts of sustainable and impact investing in part I, and what clients expect and how client advisors can serve these needs in part II, this part will focus on the investment solutions necessary to meet the identified needs. Currently, there is little that fits in terms of impact as defined in part I or value-based investment prospects that also meets the requirements for private investors.

We see three main reasons for this: impact measurement, obtaining quality data, and investor protection.

Impact measurement: not as simple as it sounds

ESG investment opportunities (funds, mandates, etc.) have become almost a standard offering for all Wealth Managers. Although this is a step in the right direction, these funds mostly use negative screening approaches to meet ESG criteria, as the measurement of impact is very difficult and not yet automated. In part I, we discussed the five-step approach as defined by the impact management project, also known as “theory of change” approach, that links impact to intent – but it’s a rocky road from theory to practice.  

One way to address this challenge could be through “impact audits” that work similarly to classical “financial audits.” For an impact audit, the first step would be an “impact business plan” as some of the start-ups are pursuing and venture capital investors are assessing. Once a company has defined what impact it wants to make and how (based on a convincing and logical “theory of change”), a regular assessment, ideally done by an independent authority, would quantify the measures and ensure solid and high-quality data that can be measured against. One pragmatic solution that keeps down costs and provides viable output is lean impact measurement. Another approach, developed by the TU Berlin together with the MIT Sloan School of Management, uses the Social Return on Investment as a basic concept for measurement and is currently used mostly for start-ups and social enterprises (see J. Horne, the sustainability impact of new ventures – Measuring and managing entrepreneurial contributions to sustainable development, dissertation, Berlin 2019). Why not use it on a broader scale? This would also help to address the second challenge:

Getting the necessary data in sufficient quality

Consider the following situation which I encountered recently: A client who is a staunch vegetarian and also spends time and money on non-profit and philanthropic activities to support animal welfare is still invested in a “classical” discretionary mandate. When asked why he doesn’t want to switch to a sustainable solution, he answers that for him sustainability is about animal welfare and organic food, but there are no solutions around that meet these specific criteria. One seemingly easy way would be to offer a portfolio that excludes industrial farming (i.e., a negative screening filter). But this is not as simple as it sounds, since there is no standard data available providing this information on a company level. A research partner would have to identify the list of companies to exclude from the portfolio. The companies would then need to be removed manually from the investment portfolio, as the research does not yield a standard set of data that is readily digestible by a portfolio management system. Needless to say, such custom solutions are only provided above a certain investment level.

What if we could go a step further? e.g., avoiding investment in industrial farming, plus supporting companies that offer alternatives like plant-based food. If one could find a standard measure of how much meat is replaced with plant-based alternatives –  resulting in less meat consumption overall, impacting CO2 emission, animal welfare, public health, just to mention a few factors – this would be a clear impact approach, as it is based on intent and has a comprehensive “theory of change:” a specific and socially positive outcome for varied stakeholders. Admittedly, these kind of companies are mostly start-ups that already thrive in the venture capital world and thus not investable for a retail investor. However, there may be other, well-established companies that also contribute to that goal, but how to measure their impact? Currently there is no standard set of data these companies provide, so there is nothing to track. But with the planned EU Taxonomy, which es part of the EU Action plan, steps into tha direction are taken. So we will see much movement in the area of data provision, hopefully allowing for automated impact calculations and identification of portfolios that optimize this impact. To reach this point, portfolio management theory needs to go far beyond the classical covariance matrix and correlation approaches. Clearly, these solutions always need to be in the best interest of the client, which leads us to:

Investor protection and impact

Investor protection is a key consideration for most of the recent regulatory developments and rightly so. But it poses hurdles for effective impact investing for non-professional clients on the product side.

As long as investments focus on liquid markets, measurement may be the greatest challenge. Plenty of investment opportunities already exist and meet regulatory requirements like weekly or daily UCITS NAV calculation needs or redemption rights. But how can liquidity be ensured in investments that go beyond liquid markets and meet investor values?

For example, if a non-professional investor wishes to invest in SMEs in developing countries, in support of his belief that local economic growth is the best weapon against migration or hunger, he has currently only two alternatives. One is to invest in a Western company that produces in developing countries under fair conditions. (It is beyond the scope of this article to discuss how to ensure that the production is really “fair” – a key challenge that needs to be considered in the many research activities around impact measurement.) Such an investment has limited impact, since most of the revenues and returns are generated by the Western company – but it does mean higher financial returns for the investor, compared with alternative investments. Alternatively, he can try to invest in stocks or bonds of a regional bank in the developing country, instead of into SMEs directly. This approach is cost-intensive as well as prone to fraud and corruption, since it cannot always be verified whether the bank invests the funds into local SMEs or supports e.g., political or military efforts by providing loans to local powers instead. Furthermore, exchange rate risk, default risk of the regional bank, and other risks remain –– and are difficult to manage, not only in a relatively small portfolio. Using funds instead may address the size issues but leads to additional costs that further reduce the return of the investment opportunity.

Thus, new investment mechanisms need to be set up that have little to do with classical portfolio management tools, and they must address these additional risks as well. Innovative solutions include cooperation with supra-national organizations, use of big data, automated controls for the processes and methods as well as for impact measurement, and the introduction of digital identities to avoid fraud. Regulatory frameworks also need to allow for more flexible and cost-efficient solutions.

Moving towards sustainability in regulation

One of the most comprehensive programs within the European Union (EU) in recent years is the Action Plan to foster Sustainable Finance. The idea behind this Action Plan is to support the EU Green Deal by moving the Financial Services industry towards Sustainable Finance. One of the key adaptations for non-professional investors is the integration of ESG criteria or similar in the advisory process  (European Securities and Markets Authority (ESMA). Final Report, Guidelines on certain aspects of the MiFID II suitability requirements, 28 May 2018).

But also legislative initiatives around disclosure of ESG and sustainability increasing transparency and the above mentioned EU taxonomy trying to standardize data (with a focus on climate change so far, but hopefully this will evolve over time) will help to address the challenges discussed in this series. But we may not forget, that theses approaches are all geared towards sustainability with a strong eye on climate change. And so, even if values and needs of clients that are outside of this sphere are not part of the development so far, it is without question an important step towards a less “risk-return only” focused investment approach. 

The key challenge for Wealth Managers is now, how they make use of this regulation and move beyond the scope of climate change and ESG approaches. Treating the new regulations as yet another “tick the box” exercise may well work for the time being, but referring back to the shift in client needs, is can – and should – be used as an opportunity to bring the discussion with the client onto another level, disucussing values and believes rather than “pure” financial goals.

So in the end, there is a great opportunity for financial institutions to combine improved client understanding and personal relationship building with innovative solutions for investment needs. For traditional banking institutions, positioning themselves this way could counter the increasing pressure from fintech and other players entering the financial services market. Their century-long experience in understanding financial needs, combined with innovative solutions, is a sweet spot that digital market players can never serve, since they don’t include the human factor – and that will always be essential in this context.

About the author:

Carina has over 15 years of experience in strategy consulting for international and boutique wealth and asset managers. While at a leading European strategy consulting firm, she advised private and universal banks and asset managers in Switzerland, Germany, and Austria and was a wealth management expert on international assignments. Her broad expertise covers offer development, advisory process re-design, pricing, post-merger integration, strategic positioning, client segmentation and market entry assessments. 

As an independent strategy advisor, Carina’s focus is on supporting strategy definition and business model transformation – including implementation support – for wealth and asset managers and family offices, taking digitalization, regulatory requirements, and sustainability/impact into account. She also acts as a sparring partner and coach for (project) managers. In 2020, Carina completed her master’s degree in Leadership in Financial Development, which furthered her passion for impact/sustainable banking and investing.