Impact investing finances companies that aim to do good in the world - here's how it works and how to get involved

Impact investing targets companies or projects committed to specific social or environmental causes.
While many perform well, the return on impact investments may be lower than more traditional investments'.
Impact investing is largely limited to private equity, but individuals get involved via broader ESG funds.
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In the past, investing for a profit and "making a difference" were two of life's lodestars that most people followed separately. But times are changing.

Investors are increasingly looking to direct their funds towards companies that are making positive social or environmental impacts in the world. The essence of impact investing is putting your principal where your principles are.

But how exactly does someone find impact investing opportunities? Is it safe and profitable to invest in social impact? Here's what you need to know.

What is impact investing?

Impact investing is the process of investing in companies, funds, or firms that are dedicated to improving the environment or society while also providing a financial return for investors.

There are a wide variety of issues that an impact investor may seek to address. These include (but are certainly not limited to):

Poverty
Hunger
Education gaps
Climate change
Pollution
Child or forced labor
Wage inequality
Diversity
Animal cruelty

Some impact investments are concessionary, meaning the company's top priority is impact rather than investor profit. But non-concessionary impact investments promise a "double bottom line," meaning that they hope to achieve their social or environmental goals without significantly hindering returns.

A recent report by the Forum for Sustainable and Responsible Investment (US SIF) found that $17 trillion of US-based investment assets in 2020 used sustainable investing strategies (a 42% increase from 2018). Put another way, a third of all assets under management in the United States now take sustainability issues into consideration.

Impact investing, ESG, socially responsible investing: What's the difference?

Environmental, social, and governance (ESG), socially responsible investing (SRI), and impact investing are sometimes used interchangeably. All three do involve the strategy of considering ethical values alongside financial values when evaluating investments. The issues that concern them overlap too.

But there are also some key differences.

ESG standards help socially conscious investors gauge a company's commitment to ethical business practices. While no single ESG rating system is used industry-wide, popular ESG data-providers include MSCI, Morningstar, Bloomberg, Sustainalytics, and more.

With SRI, investors purposefully avoid companies with products or business principles that don't align with their values. For example, SRI investors may choose to eliminate all companies that produce tobacco products or use child labor from their portfolios.

The biggest difference between ESG and SRI is that ESG tends to be inclusive and SRI exclusive. An ESG-conscious investor may still invest in companies that aren't ranked as highly as others, especially if they've expressed a commitment to improvement. But, with SRI, negative investments are typically screened out completely based on the investor's filtering criteria.

Impact investing is sometimes thought of as a subset of SRI. It can be even more exclusive in that the investments chosen are often companies or non-profits that are fully committed to specific causes. So while SRI investors may invest in any company that doesn't violate their values, an impact investor may look for companies that are fighting for values such as eradicating hunger, poverty, or other worthy pursuits.

Admittedly, it can seem a bit hair-splitting. One key point, though, is that impact investing, as the name implies, targets investments, initiatives, and companies that show measurable results - not just good intentions.

Why does impact investing matter?

Impact investing could encourage more people to get involved in efforts that have been traditionally relegated to philanthropy or charitable contributions. With the potential to achieve at least some return, more dollars may be directed towards companies that are trying to address society's problems.

Admittedly, impact investments tend to generate lower returns than the stock market as a whole. A 2017 study by the Global Impact Investing Network (GIIN) of 71 private equity impact funds found their average net return rate to be 5.8% (well below the S&P 500's average rate of return).

To be clear, this financial give-up only applies to impact investing in the strictest sense. If by "impact investing," you actually mean ESG investing, you can expect much better returns. Multiple studies have shown that investors can build ESG-focused portfolios without compromising returns. In fact, Morningstar found that in 2019, US-based. ESG funds actually outperformed their conventional fund peers.

A recent ruling from the US Department of Labor may eliminate impact investing vehicles from 410(k) or corporate pension plans. The rule prohibits fiduciary financial advisors from selecting investments based on any goals other than achieving the highest possible return for their clients.

The rule doesn't specifically call out ESG or impact investing. Still, any investments that have a below-average anticipated rate of return (as many impact investments do) could be eliminated from employer-sponsored retirement plans moving forward.

Types of impact investments

Impact investing is a diverse field - there are many ways you can invest for good. How can you find impactful companies to invest in?

Again, this depends on how strictly you define impact investing. If you actually mean ESG investing, you have many options. First, you can buy stock shares of companies that receive high ESG ratings. Or for broader diversification, you can invest in ESG mutual funds or ETFs. Leading examples include:

Online trading programs have also led the way in increasing access to values-based investing and lowering the costs. Betterment and Wealthsimple are two examples that have built their own ESG or SRI portfolios.

If you want to take the next step of investing in specific companies that are promoting social good (i.e. impact investing) things become a bit murkier. Most impact investing funds aren't publicly traded. Instead, they tend to be private equity firms (open only to institutional or accredited investors) or companies.

Accredited investors include individuals with a net worth of at least $1 million or annual income of at least $200,000 for the last two years. Or, investors who are able to demonstrate a certain level of financial sophistication.

Finding impact investing opportunities

There are several lists available online that rank impact investing funds. One example is BTheChange.com, which breaks its list of winners into five different categories:

Best for Environment
Best for Community
Best in Governance
Best for Workers
Best for Customers

The Toniic Directory is another helpful list of impact investments that includes both private equity and companies offering bonds or other fixed-income opportunities.

Accredited-level investors may want to look for private equity firms that focus on impact investing. Notable impact investing firms include Sonen Capital, Calvert Impact Capital, and Reinvestment Fund.

Some examples of impact investing

Let's say that you're passionate about environmental issues like reducing carbon emissions and the use of non-recyclable materials. To find an impact fund that suits you, you may start by checking out the "Best for the Environment Funds" on BTheChange.com.

After perusing the list, you visit the website for Arborview Capital, a firm that invests in businesses that support each of the environmental goals listed above and more. Feeling strongly that your values align, you make the decision to invest in the Arborview Capital Partners II LP fund.

In another example, imagine that you feel strongly about investing in local businesses that serve low-income communities. In that case, you may be drawn towards investing with the Reinvestment Fund.

Reinvestment Fund's promissory note program supports the "triple bottom line" of People, Planet, and Profit. After reviewing your note options, you decide to invest in a 7-to-9-year promissory note that will pay you back at an interest rate of 2.25%.

The financial takeaway

If you're just getting started with socially conscious investing, you may want to start with ESG ETFs and mutual funds. As publicly traded assets, they are easy to buy (or sell) and generally earn solid returns as well.

But if you have a net worth that's on the high side or considerable investment expertise, you may be willing to deal with less liquidity and lower returns in exchange for making a bigger difference. And, in that case, it could be highly rewarding to invest in private funds and firms that are wholly focused on making a positive impact in the world.