Advisors: Incorporating Impact Investing in Client Portfolios

Impact investing, a type of socially responsible investing, refers to investing with the intention of creating a positive social or environmental impact. There are many different impact investing funds that vary by strategy, return objectives and impact goals. Increasingly, financial advisors are encountering clients who ask for these kinds of investments in their portfolios. But it's not enough to simply understand the difference between impact investing and SRI (and the related ESG options).

Many impact investing options are international, creating an additional layer of risk that investors need to take into account. Advisors who understand these risks, and who can explain them to clients, will be better positioned to select the appropriate impact funds for a portfolio. When evaluating impact funds, the more unique risks to consider for the investor in question include political, currency and exit risk.

Political risk refers to the risk related to instability in a country. When evaluating the political risk exposure of an impact investing fund, it is important to consider whether the fund invests in many different countries or has a regional or even single country focus.

Investing in many countries carries with it the advantage of diversification. A loss due to political risk in one country will only affect a small portion of the portfolio. Many funds use a diversification approach, with some funds explicitly stating they won’t invest more than a certain percentage in a single country or region.

On the other hand, it may also be possible to reduce political risk by only investing in one region or even a single country. This focus allows portfolio managers to select countries or regions based upon their level of political risk. Also a regional or country focus may allow an advisor to better understand, monitor and mitigate the political risk exposure of their investments. (For related reading, see: 5 Reasons Advisors Need to Rethink Impact Investing.)

Currency risk is of importance in any international investment but of particular importance in impact investing. Many impact investments are in countries with volatile currencies and currencies that may lack hedging mechanisms.

It seems the simple answer is to make the investments and repayments denominated in a major currency such as the dollar or euro. This strategy fails to mitigate currency risk if the investee conducts a large portion of its business in the local currency. An unfavorable change in the exchange rate of the local currency relative to the dollar or euro will make repayment of the investment difficult for the investee.

To significantly reduce currency risk, it is better to search for countries that have less volatile local currencies or countries that have adopted (officially or unofficially) the dollar or euro as their currency for commerce. The risk can also be mitigated if hedging mechanisms, such as futures contracts, are available in the local currency. As noted above, hedging in developing market currencies is not always possible and can be quite costly.

Exit risk is the risk it may be difficult or impossible to exit an investment. This brings up the important question of whether the impact fund is investing in debt, equity, or another instrument. Debt investments generally carry minimal exit risk as the investee makes payments directly to the fund. Equity investments can carry large exit risks as developing markets may not have an accessible way to exit an equity investment, such as a liquid secondary market. If you're considering an impact fund that makes equity investments for a client, ensure the fund management has a clear strategy on how to exit the investments.

When comparing impact investing funds, advisors will want to keep these risks in mind and understand the fund manager’s strategy for evaluating and mitigating these risks. With the right amount of planning, impact investing funds can offer attractive yields for clients while generating positive social or environmental impacts. (For more, see: A History of Impact Investing.)