Sustainable investing, previously a niche topic, has gone mainstream. The vast majority of Americans favor bold action on climate change mitigation, and in recent years the financial services industry has risen to the challenge with a broad offering of climate-forward securities and funds. One unique fund structure has the potential to overturn the paradigm of what it means to "invest sustainably" – and it has gone largely overlooked until now. Here's how the interval fund might just be the future of ESG.
FIRST: WHAT'S ESG INVESTING?
That’s a surprisingly difficult question to answer. The acronym “ESG,” stands for “environmental, social, and governance.” These three descriptors are shorthand for an expanded system of values-based investment that’s being applied to the financial world by an increasingly climate- and justice-focused public. It’s used interchangeably with “sustainable investing” to describe capital management based on more than just profit.
According to Morgan Stanley, the majority of Americans already take part in sustainable investing. Ninety-five percent of Millennials, a generation that controls a growing share of the world’s invested assets, are interested in ESG. And it isn’t just a passing fad. Morningstar reports that over $51 billion flowed into sustainable funds in 2020 alone, and Bloomberg predicts that a third of global assets will be managed under a sustainability mandate within the next five years. That projected $53 trillion has the potential to make massive progress in the global fight for environmental sustainability and human rights. However, the way that capital is invested matters tremendously.
THE PROBLEM WITH ESG
The current sustainable investing model dilutes investor impact. Mutual funds and exchange-traded funds (ETFs) are by far the most popular investment vehicles, containing about 98% of US assets under management. These funds have broad appeal; they tend to have low management fees, they’re easy to buy and sell, and they tend to have straightforward holdings and goals.
But 65% of investors still cite a lack of high-quality sustainable financial products as a barrier to growing their ESG portfolios. That may owe in part to the convoluted financial pipeline between making an investment and seeing its impact. Although mutual funds and ETFs might label themselves as “sustainable,” what does that mean?
Relatively little, as it turns out. The issue comes down to what the funds can hold. Because they must be able to sell their investments at any time to support their “easy-in, easy-out” appeal, 97% of sustainable mutual funds and ETFs focus on high liquidity securities like publicly traded stocks or corporate bonds. Therefore, capital that makes it to the funds’ holdings is filtered through a sieve of corporate overhead before being applied to the impactful products and services the investor is targeting with her money.
Photo by Romain Dancre
Investing $1,000 in an ETF focused on clean energy doesn’t mean that you’re creating $1,000 worth of solar panels and wind turbines. For ETFs, almost nine in ten shares are purchased from other investors on a secondary market, and thus don’t involve any net capital flow to the companies the fund holds. Instead of leading to the purchase of more stock in the fund’s underlying holdings, these transactions of shares occur only between traders. And even the fraction of trading volume that makes it to impact-oriented firms through the purchase of stock doesn’t go straight into deployment in green projects. It must first be filtered through layers of overhead, salaries, and fees before it’s used to fund activities and products with a measurable impact.
SOLUTION 1: DIRECT INVESTMENT
Interval funds present an opportunity to invest in the assets that actually build a better future. This access comes through the investments that interval funds were designed to hold: alternative assets.
Alternative assets are diverse. They include types of investment that don’t trade on stock or bond exchanges, or those which are difficult to buy or sell quickly. Examples include real estate, collectables, stock in private companies, infrastructure project debt, and gold. But why are alternatives the avenue to direct impact?
The short answer: debt financing for sustainable assets. Companies, governments, or individuals who want to pay for projects like solar panels, sustainable forestry projects, or efficiency upgrades on buildings need to raise money. To do this, they can issue project debt – bonds linked directly to the asset that’s being built, rather than the company or government overseeing it. High-impact physical projects, like watershed restorations and wind farms, are perfect contenders for fixed-income, long-term debt. They have high up-front costs that require a lot of money to be raised, and then they have a steady pay-out with which they can reimburse those who finance the initial push.