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Impact Investing: The Performance Realities

Investing with your conscience no longer has to mean sacrificing potential returns

IMPACT INVESTING MEANS DIFFERENT THINGS to different people, but generally it refers to investments made in companies, organizations and funds with the intention to generate measurable social and environmental impact alongside a financial return. Impact investing, originally referred to as socially responsible investing, was previously limited to screening stocks or industries to eliminate companies whose practices did not align with the investor's values. It has significantly evolved as an investment and risk management approach, and it now may enable investors to reflect environmental, social and governance (ESG) considerations in their investment portfolios without having to sacrifice potential returns. Strategies span asset classes and issues such as climate change and access to finance, health care and education, letting investors simultaneously pursue both financial and nonfinancial goals.

Institutional investors were among the first to incorporate impact investing criteria into their mandates, and they still account for the largest share of assets. However, recent substantial growth in sources of ESG data as well as a rising number of private companies that have dual objectives of financial and social returns now make it possible for all investors to incorporate impact investing into their portfolios. For example, in 2011, only 20% of the S&P 500 companies issued reports on their corporate social responsibility. By 2014, that number had jumped to 75%.1 The number of investment funds incorporating ESG factors has nearly doubled in that time period (from less than 500 funds in 2010 to more than 900 in 2014), and assets have risen roughly 650% (from $569 billion in 2010 to $4.3 trillion in 2014).2

In 2011, only 20% of the S&P 500 companies issued reports on their corporate social responsibility. By 2014, that number had jumped to 75%.

A different climate for impact investing
While many investors are interested in reflecting environmental or social issues in their investment portfolios, they have traditionally held back because of a commonly held belief that it would require a trade-off in performance. It is true that the historical standard of negative screens can amplify risk by reducing diversification and potentially cause unintended concentration of specific firms or sectors, resulting in a portfolio's underperformance. However, we believe that a combination of more reliable data, enhanced portfolio construction techniques, and innovation in structures and investment approaches is starting to reverse that outdated mentality. These structural changes support a growing body of evidence showing that investors can do well financially by investing in organizations that are doing what's right for the environment and society.

Many impact investments can be used in a market-based portfolio without sacrificing potential returns and without significant increases in risk. In fact, studies have shown that companies demonstrating ESG principles have been able to reduce risk and potentially enhance shareholder value. For example, a 2014 study by the climate change organization CDP found that S&P 500 industry leaders on climate change generated 18% higher return on equity (ROE), 50% lower volatility of earnings over the past decade, and 21% stronger dividend growth than their peers that had low scores for responding to climate issues.3 Another study by the firm Analytic Investors showed that companies with a higher ESG rating tended to have a more stable pattern of returns, potentially helping to better preserve capital in a portfolio.

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An array of choices can meet needs and preferences
The risk and return characteristics of impact investments that are illustrated in the accompanying table can vary, and understanding them is critical for investment decision-making.

For example, investors in an alternative energy strategy are using capital to create a positive impact on the environment. So in addition to having the potential for lowering carbon emissions, investors are expecting a higher return because alternative energy companies are working in a high-growth-oriented space. Conversely, investment strategies that focus on microfinance and community development offer a significant potential for social impact, but often yield lower returns than traditional strategies with credit risk that is not rated by a reputed agency. This is due to the fact that there needs to be a cap on the financial return for investors to avoid diluting the benefit to low-income communities.

A U.S. Trust survey found that 60% of millennials and 34% of Gen Xers are interested in or currently use social impact investments.4

Impact investing is poised to grow in significance in the coming years. According to the 2015 U.S. Trust Insights on Wealth and Worth survey, younger generations see no reason to separate investing and impact, which is why 60% of millennials and 34% of Generation X are interested in or currently use social impact investments. Increasingly better data and improved portfolio construction techniques that make it even easier to integrate impact into an investment process, without sacrificing returns, will only help speed this along.

Adapted from "Impact Investing: The Performance Realities," a white paper by Anna Snider, Global Head of Equity and Impact Investing Due Diligence, Merrill Lynch Global Wealth and Retirement Services (November 2015).

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1 Governance & Accountability Institute Flash Report, June 2015. http://www.ga-institute.com/nc/issue-master-system/news-details/article/flash-report-seventy-five-percent-75-of-the-sp-index-published-corporate-sustainability-rep.html

2 US SIF, Report on US Sustainable, Responsible and Impact Investing Trends, 2014.

3 CDP, Climate Action and Profitability, 2014. Past performance is not a guarantee of future results. www.cdp.net/CDPResults/CDP-SP500-leaders-report-2014.pdf

4 U.S. Trust is a division of Bank of America, N.A., Member FDIC

Alternative Investments are speculative and involve a high degree of risk. An investor could lose all or a substantial amount of his or her investment. Interests in funds may be illiquid and subject to restrictions on transferring fund investments. Funds may be leveraged and performance may be volatile. Funds are subject to substantial fees and expenses, which may offset any trading profits.  Some or all alternative investment programs may not be suitable for certain investors.

Alternative Investments, such as hedge funds and private equity, can result in higher return potential but also higher loss potential. Before you invest in alternative investments, you should consider your overall financial situation, how much money you have to invest, your need for liquidity, and your tolerance for risk. Some or all alternative investment programs may not be suitable for certain investors.

An offer to purchase Interests in a Social Impact Partnership or Social Impact Bond offering can only be made pursuant to a Confidential Private Placement Memorandum  (“PPM”), which contains important information concerning risk factors, conflicts and other material aspects of the Company and must be carefully read before any decision to invest is made. Social Impact Bonds are a new and evolving investment opportunity which are highly speculative and involves a high degree of risk. An investor could lose all or a substantial amount of their investment. There is no secondary market nor is one expected to develop for these investments and there may be restrictions on transferring such investments. The specific terms of any individual offering may provide for substantial or total loss in the event that specific targets are not met and must be carefully reviewed with the various potential outcomes carefully considered.

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