Can Public Equity Investing Have Impact?

There's an argument in the world of impact investing that goes something like, "impact happens only through private investments; there is no real impact, apart from shareholder engagement efforts, in public equity investing." An associated perception is that investment impact means capitalizing an enterprise beyond what would happen otherwise, meaning private equity alone has the power to provide real impact. But is this true?

Publicly traded corporations are the largest and most visible social and environmental bellwethers of the global economy, and the high allocation to public equities in most investor portfolios means public equity investing is and must remain one of our key opportunities for impact. To cause a positive impact, families, institutions, and individuals can invest in public companies whose primary business activities address pressing social, economic, and environmental challenges at scale. This does not mean companies with a pretty sustainability report or that are incrementally making their operations less carbon-intensive, but firms that have made it their purpose to enable a better world with an indefinitely sustainable economy. Skipping traditional investment practices to focus on buying these companies sends the clear signals that markets do value solutions, and that markets will devalue businesses that are the leading causes of our most pressing risks. In addition, flexible, go-anywhere public equities strategies may invest in micro and small cap firms where there may be limited liquidity, and we can have meaningful impact just by being there.

Clearly, how we invest in public equities matters.

A growing number of public markets strategies are being developed to meet investor demand for solutions-focused investing. These strategies (including Green Alpha's own) are pushing boundaries in terms of how managers define risk, and are challenging preconceptions from traditional portfolio theory in order to invest in the best solutions to the dangers presented by the business-as-usual economy. Public equity portfolios can have real impact, and yet we must acknowledge that the perception that they do not exists. But why is that?

The Index Trap for Impact

Most investment managers have been trained to think about risk-adjusted returns in the same way, and in the case of equity strategies, that means making sure to exhibit correlation with your self-identified and/or assigned benchmark, usually the S&P 500 or other broad-market index. A competitive absolute return can still be considered a poor risk-adjusted return if you have more volatility along the way than your underlying benchmark. This can be traced back to the near-universal indoctrination into Markowitzian modern portfolio and efficient-market theories, popularized by Jack Bogle and others.

Bogle's saying, "Why look for the needle when you can buy the haystack," has come to mean "if you vary from the haystack, you may be punished." This index-supremacy has been institutionalized to the point that rating agencies have a hard time imagining risk defined any other way than relative benchmark correlation, or how much a portfolio looks like the broad market. Morningstar, for example, determines its star ratings for equity funds on the basis of absolute return vs. the peer group bench, less any deduction for higher volatility than the peer group. In this way, some funds can and do beat their peer group's performance over time, yet receive a rating of two or three stars (out of five) despite overall superior returns. Thus, fund managers, fearing for their retail sales, try very hard to mimic their benchmark, ideally outperforming it by a little but not enough to be considered "volatile."

The overall result of all this is too many dollars chasing the same benchmark constituent companies, leading to unintended consequences such as, for example, the average S&P 500 firm right now having negative 12-month forward earnings per share (EPS) growth rate, yet at a high average price-to-book value near 3. Not great from a value point of view, which to me shows this culture of index-homogeneity is causing market distortions. Moreover, indexing and index-mimicking generally ignore a lot of interesting innovation that occurs outside of index constituent companies, which is unfortunate because this innovation is where a lot of economic growth occurs, and also where we confront and solve the realities our most pressing systemic risks.

Thus, to have impact, we must recognize that equity investing can actually involve companies not found within traditional benchmarks, and, with some financial analysis, interesting portfolios can be constructed and opportunities can emerge. So it is imperative to look as closely at our public equity holdings as we do at our private equity investments, and also, equally, to stop concerning ourselves with correlation to traditional indexes.

Real impact depends upon voting with your dollars for the future economy, for the actual catalysts of change, for the viable growth areas where we can reasonably expect to earn good equity growth in this era of rapid change. This means a higher level of due diligence that avoids the trap of thinking public equities are "set it and forget it." Even when selecting funds that market themselves as sustainable, it is key to do your homework. Many green public equity funds correlate very closely with the S&P 500, meaning they are still largely invested in the legacy economy, which of course is a lousy way to have impact with your public equity dollars. In fact, the prevalence of investment funds that hug their benchmark first and think about impact second is why it is so commonly assumed that public equity investing can't have impact.

Well, it's not that public equity portfolios can't have impact, it's just that they usually don't. But if we can change the way we think about risk and indexing in public equities, we can and will see real impact ripple around the world.

So, where to invest?

Next Economy, Innovation Economy

If economic history shows us nothing else, it is that innovation and better products and systems that perform better and cost less always win in the marketplace. And this is what sustainability is - innovation-led gains in efficiency that mean we can have a thriving economy while lessening our footprint on our required yet delicate earth systems. It's imperative to direct capital into the future that you in fact see coming, in part through public equity investing. That investment represents real impact and also positions your stock portfolio to grow as that future emerges and grows, supplanting the old fossil-fuels based economy.

For investors, the best Next Economy solutions simply outperform their old economy counterparts and predecessors, all while circumventing our most daunting long-term risks. In addition, there's now a growing demographic demand from women and millennials for solutions-oriented investments that are growing in size and wealth as part of the $40 trillion wealth transfer that is occurring in the U.S. In short, we're at the early stage of share price appreciation for meaningful, scalable solutions.

In this light, we view investments through a holistic lens, and therefore deploy impact on the world across asset classes of private equity, public equity, and debt. In other words, if you have a commitment to impact, it's not just a private equity hobby, it's across all classes. Again, strategies dedicated to seeking equities that are solving big risks by investing in solutions amplify powerful market signals that firms with proven business models addressing challenges around climate and resource scarcity are now highly valued.

In the case of public equities, this does mean letting go of the idea that high correlation to the old indexes is somehow safer or even a good way to measure risk. Investing in public equities that are addressing looming systemic risks means looking for companies where financial return drivers and impact are inextricably linked, without regard to how well this tracks the S&P 500 or any other old index.

Public equity is a core component of a diversified investment portfolio - why would we not seek maximum impact from this key piece of our total assets? Next Economics, focusing on what the de-risked economy will look like, and building portfolios that reflect that economy now, is compelling both in terms of affecting change and also in terms of financially benefiting from that change: Impact.

Disclosure: None