Interest in impact investing is growing at an accelerated pace. Impact investors want their money to have a positive social or environmental impact, but they also care about the risk and return of their investments. To this end, impact investors have three objectives (risk, return and impact) rather than the two (risk and return) that traditional investors care for. To determine the optimal trade-off between risk and return, traditional investors rely on portfolio optimisers. However, such optimisers do not include impact. As a result, impact investors use ad hoc rules to allocate to impact funds. Such allocation strategies are inefficient, as they ignore the correlations between impact asset returns and traditional asset returns. Taking these correlations into account allows for better portfolio diversification.
We developed a "three dimensional" portfolio optimiser which brings together impact funds and traditional assets. By reflecting how impact and traditional assets interact, the optimiser finds the best trade-off between risk, return and impact.
We compare optimal portfolios with the customary allocation of an impact investor who simply carves out a portion of their assets for impact funds. Optimisation can achieve superior risk, return and impact outcomes, and the benefits can be large. Our optimiser allows an investor to potentially increase impact by ~20% without financial sacrifice.
Impact investing is developing fast, therefore tools to integrate impact funds into mainstream investment are especially timely. We expect asset managers to routinely use similar tools in the coming years.
- The 3D Impact Optimiser has three dimensions: risk, return and impact. Intuitively, returns from impact funds correlate with traditional asset returns. Taking such correlations into account allows for better portfolio diversification. That is, investors can achieve higher impact without hurting risk-adjusted returns.
- Diversification benefits can be large. Our optimiser allows an investor to increase impact by ~20% without financial sacrifice.
- Demand for impact investing is rising. Tools that help integrate impact funds into traditional portfolios are therefore useful and will likely soon become widespread.