Building an impact portfolio is a very personal exercise, and one that should start with a vision. The investor's priorities ultimately become the driving force behind portfolio construction. Fortunately, there are many ways to incorporate one's personal vision into an impact investment program.
It's About Implementation
Since the decision to focus on impact is a "values" decision, it's unlikely that this choice affects an investor's risk tolerance or return objectives. So, the principles that underlie sound portfolio construction and risk management should remain constant across investor types. The differentiation between investor profiles is not in their basic portfolio structure then, but in their implementation. Put another way, the allocation pie charts should look the same. How you fill each slice of the pie with specific investment vehicles is where investors differ.
Alignment, Impact or Both?
For most investors, the initial questions are about their publicly-traded stock portfolio. So, their actions are usually not about impact at all, but about alignment. This is more than semantics. Let me explain.
At its core, alignment is an inwardly-focused exercise where securities are selected only if they align with the investor's vision for the portfolio. Industry exclusion has long been the "blunt instrument" by which investors can align their holdings with their values. So-called "controversial industries" can easily be excluded from an individual stock portfolio.
Taking this a step further requires deciding on a ranking methodology -- scoring each holding based on the investor's priorities. This will show which of the current holdings can be retained and which must be replaced. And ultimately, a diversified stock portfolio that meets the investor's social objectives will become a core part of their overall investment plan.
In contrast with alignment, impact is an externally-focused activity. Investments most easily make an impact when they add something new to the World -- a concept known as "additionality". It's inherently more difficult to achieve additionality by buying shares in a publicly-traded company -- you merely bought them from someone else, and nothing new was created. But when one invests in a new enterprise -- building renewable energy facilities, for instance, or when one finances an early stage clean technology company, they have unequivocally added something new. Without the investor's additional capital, these ventures would not have happened. If successful, these investments create an impact.
In practice, investors employ both objectives in portfolio construction -- investing for alignment and impact.
Engagement versus Divestment
While it requires some real effort, even if an investor's portfolio is confined to public securities, they can still make an impact. Take the example of the environmental investor again. She may choose to have a fossil fuel-free portfolio, divesting her account of any such companies. Or, she may choose to retain these holdings with the objective of engaging management in an attempt to influence their behavior.
It's hard to make an impact through divestment, but engagement has been shown to work when increasing numbers of investors press for similar changes. At some point, the movement can gather momentum, and the cost of capital for such firms becomes too high for them to continue their unfavorable activities. Eventually, banks stop lending to them. The coal industry is one such example where investor pressure resulted in many firms being starved for funding.
Setting YOUR Priorities
Whether through alignment or direct impact, investors may choose to employ techniques that are specific to each asset class. Public securities might be subject to divestment from certain industries and engagement in others. Private investments might be part of the mix in order to focus on certain segments that are particularly important to the investor. Still other investments, such as government bonds, might be seen as "neutral" -- neither providing a positive nor a negative impact, but still included in the portfolio for risk/return reasons.
In the end, impact investors set their own priorities and decide where they can most effectively obtain the financial and social benefits that they seek.