by Garvin Jabusch
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 businesses 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-markets theories,
popularized by Jack Bogle and etc.
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 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.
Garvin Jabusch is cofounder and chief investment officer
of Green
Alpha®Advisors, LLC. He is co-manager
of the Shelton
Green Alpha Fund (NEXTX), of the Green
Alpha Next Economy Index, and of the Sierra
Club Green Alpha Portfolio. He also authors the Sierra
Club's economics blog, "Green Alpha's Next
Economy."