economically targeted investment
TRANSCRIPT
Economically Targeted Investment: Societal Impact through Private Financial Returns
Valeriy Filatov
University Honors in Business Administration
American University, Kogod School of Business
Advisor: Prof. Richard Linowes, Department of Management
Spring 2012
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Abstract
While traditional investing maximizes the risk-adjusted financial return of an investment in the
context of an overall portfolio, it does not account for an investment’s externalities, or its non-financial
impact. This paper aims to serve as a guide for investors seeking to both receive financial returns and
have a positive impact on society. The first part of this paper discusses the societal impact of financial
investments, which consist of their net social, environmental, and economic effects. Societal impact can
have an indirect, yet potentially significant, effect on an investment as a consequence of local economic
growth and reputational risk.
The second part of this paper investigates economically targeted investing (ETI), a form of
responsible finance. Responsible finance is an approach to evaluating investments based on their total
financial and societal returns. ETI seeks to achieve a competitive financial return while maximizing
societal benefits to specific geographic areas underserved by financial institutions. Investors are able to
follow a variety of approaches to ETI that may prioritize financial returns, diversification, or societal
impact. While their size would allow them to create substantial societal impact, pension funds are
subject to regulation that effectively minimizes their ability to pursue non-financial returns. Ultimately,
regardless of their legal structure, investors in ETI must take care to avoid sacrificing financial return for
an incommensurable level of societal impact.
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Table of Contents
Abstract................................................................................................................................................... 2
Traditional Investment ............................................................................................................................ 4
1. Economic and Societal Impact ................................................................................................. 5
2. Externalities ............................................................................................................................ 6
3. Societal Impact ....................................................................................................................... 8
Responsible Investing ............................................................................................................................ 10
4. Economically Targeted Investments ...................................................................................... 12
5. Types of Economically Targeted Investments (ETI) ................................................................ 15
6. Characteristics of ETI ............................................................................................................. 16
7. Investors in ETI ...................................................................................................................... 16
8. Benefits of ETI ....................................................................................................................... 17
9. A Selection of Public Pension Funds Engaged in ETI ............................................................... 18
10. Effects of Pension Fund Regulation ....................................................................................... 18
11. Previous Investment Losses in ETI Portfolios ......................................................................... 20
Conclusion............................................................................................................................................. 21
Works Cited ........................................................................................................................................... 22
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Traditional Investment
Investing is the current commitment of money or other resources in the expectation of earning
future benefits.1 By deferring consumption today, individuals can invest their savings by investing them
with parties with a shortage of financial capital, allowing them to earn financial returns.2
Investment decisions have a risk-return trade-off, in which investments with greater risks
provide higher levels of compensation.3 Three of the most significant investment-associated risks
include:
Business risk (or operating risk): the possibility of a firm experiencing a loss or lower than
anticipated profits.4
Liquidity risk: the possibility that an asset cannot be sold rapidly without a significant discount
due to the low amount of trading in the asset.5
Financial risk: the possibility of loss as a consequence of being a low-priority creditor, such as a
holder of equity or subordinated debt.6
Default risk (or credit risk): the likelihood of loss due to a debtor’s inability to make payments on
obligations.7
As a result of investment risks, investment decisions are made to maximize the financial returns
per unit of risk assumed by an investor, according to modern portfolio theory.8 Developed by Harry
Markowitz in 1952, modern portfolio theory stipulates that investing decisions should be based on their
effects on the overall portfolio in order to take into account the effects of diversification. 9
Diversification results from the imperfect correlations of individual assets (ρ < 1). By spreading an
investment across multiple imperfectly-correlated assets, it is possible to create a portfolio with a lower
level of volatility than the underlying assets, creating what is known as the minimal-variance portfolio.10
Traditional investing and valuation of investments based on modern portfolio theory takes into
account the financial risks and returns of investments. Universally accepted financial models such as the
Capital Asset Pricing Model take into account both market and firm-specific risks such as liquidity risk,
financial risk, and default risk. Investors require risk premiums as compensation for increased risk
exposure.
1 Bodie, Zvi, Alex Kane, and Alan J. Marcus, 3.
2 Ibid, 4.
3 Ibid, 10.
4 "Business Risk." Investopedia. Investopedia, 2012. Web. 10 Dec. 2012.
5 Brunnermeier, Markus K., and Lasse Heje Pedersen. "Market Liquidity and Funding Liquidity." NYU
Stern School of Business. NYU, 2008. Web. 10 Dec. 2012. 6 "Business Risk." Investopedia.
7 Ibid.
8 Bodie et al. 9.
9 Markowitz, Harry. "Portfolio Selection." JSTOR. The Journal of Finance, 1952. Web. 17 Dec. 2012.
10 Markowitz, Harry.
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Economic and Societal Impact
The majority of investment decisions are made based on their financial risk and return, or
financial benefit. However, in addition to their financial return to the investor and access to capital for
the borrowing firm, investments also have indirect effects on the surrounding society. An investment’s
societal effects are comprised of its impact on the economy and the impact of its non-financial
externalities.
The economic impact of an investment is comprised of three parts: direct impact, indirect impact, and
induced impact.11 Economic impact ultimately affects economic growth.
Direct impact consists of a firm funding its operations, which includes expenditures on
inventory, wages, operating expenses such as utilities, and investment into future productive
opportunities. 12
Indirect impact is a multiplier effect that is caused by the purchases of goods and services from
other businesses.13
Induced impact consists of the additional consumer spending resulting from household spending
of income earned directly or indirectly from a firm’s activities.14
According to the macroeconomic expenditure method of calculating GDP, economic growth is caused by
increases in spending.
Businesses raise capital in order to expand their productive opportunities; this increases labor
demand. An increase in labor demand creates jobs for local individuals, who experience an increase in
disposable income. In turn, greater disposable income leads to greater consumption; ceteris paribus,
this leads to economic growth. As a result of their economic impact, investments have an effect that is
greater than the return to the investor alone. The effects of a single investment have an incremental
effect on all of society in proportion to individuals’ relationship to the firm.
Traditional investing largely ignores the externalities caused by investments, or the effects of
economic activities created by an economic agent other than the one who is affected.15 Externalities are
a market failure, or a transaction spillover that is not transmitted through prices.16 Investments may
11
"The Multiplier Effect of Local Independent Business Ownership." AMIBA. American Independent Business Alliance, 2012. Web. 17 Dec. 2012. 12
Working paper. The Economic Impact of the U.S. Retail Industry. PricewaterhouseCoopers, 2011. Web. 13
Ibid. 14
Ibid 15
Brainard, William, and Hanming Fang. "Externality Versus Public Goods." Duke University. Duke University, Spring 2003. Web. 16
Caplan, Bryan. "Externalities." The Concise Encyclopedia of Economics. Library of Economics and Liberty, 2008. Web. 7 Dec. 2012.
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have negative or positive externalities, which can be affected by regulation or market-based incentives
that affect the costs of certain types of behavior. For instance, polluters are subjected to regulation
limiting the maximal permitted amount of pollution, and tax credits have been used to encourage
investment in energy-efficient appliances.17 These are examples of Pigouvian taxes, which attempt to
minimize externalities via a tax that is equal to the societal cost of an externality. 18 However, regulation
cannot factor in all externalities and may create additional externalities – such as by causing businesses
to pass the costs of regulation along to their customers.19
Externalities Negative Externalities Positive Externalities
Summary “privatized gains, socialized losses” “socialized gains”
Definitions
Costs experienced by third parties as a result of economic activity.
Benefits enjoyed by third parties as a result of economic activity.
Net economic losses experienced by society are greater than the net costs and benefits experienced by private actor(s) responsible for the behavior.
Net economic losses experienced by society are greater than the net costs and benefits experienced by private actor(s) responsible for the behavior.
Examples
Environmental pollution
one polluter imposes clean-up costs and healthcare expenses on society
Network effects
a benefit to all users of a product from adding more users
Noise pollution
Noise produced by a private actor is a nuisance to locals
Preventative care
The reduction of an individual’s risk of disease also reduces society’s risk by reducing transmission rates
Over-use of common resources
Individuals’ consumption in self-interest leads to the depletion of a shared resource “Tragedy of the Commons”
Knowledge Spillover
The development and creation of new and derivative works arising from previous ideas, increases in education, and the exchange of ideas
Moral hazard A party that receives the benefits of its actions but not held accountable for its risks
Neighborhood development
Improvement of privately-owned properties that leads to a rise in all real estate prices in the area
17
"Federal Tax Credits for Consumer Energy Efficiency." Federal Tax Credits for Energy Efficiency. ENERGY STAR, 2012. Web. 9 Dec. 2012. 18
Pigou, Arthur C. "The Economics of Welfare." The Economics of Welfare. Library of Economics and Liberty, 1932. Web. 8 Dec. 2012. 19
Lewyn, Michael. "What Would Coase Do? (About Parking Regulation)." Social Science Research Network. Social Science Research Network, 30 June 2010. Web. 11 Dec. 2012.
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While an investment may have a variety of externalities, they are rarely taken into account.
Externalities can consist of social, environmental, and other non-financial impacts on the society.
Financial markets do not account for externalities that do not present economic risks to the business.
This “fails to yield efficient outcomes from a general welfare perspective,” as it externalizes the true
costs of business onto the society.20 It is often difficult to measure the true effects of externalities as
many benefits cannot be accurately quantified. For instance, while inoculating an individual against a
disease benefits the society via reducing the likelihood of its transmission, it is not possible to place a
price on the social gain. Also, as with carbon taxes, attempting to address the societal costs of
externalities can become a political issue.21 Externalities are a form of non-financial return experienced
by society.
Externalities can be assigned to multiple categories. The European Venture Philanthropy
Association uses the term “societal impact” to summarize the spectrum of non-financial returns. Societal
impact is the total social, environmental, medical, and cultural impact of an investment.22
20
Helbing, Thomas. "Externalities: Prices Do Not Capture All Costs - Back to Basics: Finance & Development." Finance & Development. International Monetary Fund, 28 Mar. 2012. Web. 11 Dec. 2012. 21
Rabe, Barry. "The Political Viability of Carbon Taxation." Brookings. The Brookings Institution, 5 Dec. 2012. Web. 17 Dec. 2012. 22
"European Responsible Investing Fund Survey." European Responsible Investing Fund Survey. KPMG, 11 May 2012. Web. 8 Dec. 2012.
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Societal Impact23
Type of Impact Definition Examples
Social Impact
Initiatives which increase the quality of life of individuals and societies by improving their economic and social well-being.
Business activities in conflict zones
Workplace health safety and quality
Labor standards for suppliers
Policies on child labor
Payment of a fair or “living wage”
Improvements in living conditions
Job creation Improved access to staple goods
Relationships with local communities
Environmental Impact
Initiatives which minimize their ecological footprint and/or aim to address environmental degradation or climate change.
Minimization of ecological footprint
Development / use of sustainable technologies
Conservation Addressing biodiversity loss
Energy efficiency
Investing in renewable energy
Waste management and recycling
Carbon Investment Vehicles
Sustainable Forestry
Clean water initiatives
Medical Impact
Initiatives which prevent, treat, and/or cure illnesses through medical attention and medical research.
Research of illnesses and medical disorders
Development of treatments
Vaccination programs
Improving access to medicine through methods such as public clinics
Cultural Impact
Initiatives which improve public access to the arts, music, and literature.
Providing funds to museums, libraries, theaters, and other similar organizations via investments, subsidized and market-rate loans, and grants (or donations)
While the non-financial impact largely affects society, the economic and social impact can
ultimately affect financial returns. Non-financial impact represents a source of reputational risk to the
investor and borrowing firm.24 If a company is exposed by the media to negatively affect society (such as
due to unfair labor practices or pollution), it can face a public backlash that can lead to lower revenues.25
On the other hand, firms that have an outsize impact in the improvement of society are likely to gain
extra business due to its reputation. In the long run, a firm’s economic impact can also lead to above-
average economic growth in its place of business, which would contribute to a faster growth of
revenues.
23
Ibid. 24
"Investing for Impact." Credit Suisse Research Institute. Credit Suisse, 2012. Web. 6 Dec. 2012. 25
Ibid.
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Finally, while investments may be made in a manner that maximizes financial return, the non-
financial impact may negatively affect investors’ other sources of income. For instance, the facility
management company Aramark won a contract to oversee custodial services in Chelmsford,
Massachusetts for $400,000 less than the custodians’ union, who lost their jobs after refusing pay cuts
from $20 per hour to $8.50 per hour. The pension fund of the custodians’ union had a private-equity
investment that included Aramark.26 The externalities of an investment become increasingly important
with the increase in investment size. As a consequence, the analysis of an investment’s non-financial
impact becomes increasingly relevant in the overall evaluation process. The non-financial impact of each
investment should be considered in aggregate – after taking into account the investor’s perceived
importance of each type of non-financial return.
26
Braun, Martin Z., and William Selway. "Pension Fund Gains Mean Worker Pain as Aramark Cuts Pay." Bloomberg.com. Bloomberg, 20 Nov. 2012. Web. 28 Nov. 2012.
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Responsible Investing
Responsible investing is a movement to monitor both financial and non-financial returns of
investments.27 It was created in 2005 and has been primarily shaped by the United Nations Principles for
Responsible Investment Initiative (PRI). PRI is a voluntary framework formed by the investment
community that promotes the viewpoint that environmental, social, and corporate governance
measures, or ESG, can affect the performance of investment portfolios. PRI includes voluntary
commitments to the inclusion of ESG principles into investment selection and management. As of April
2012, over 1,000 investment institutions with approximately US$30 trillion in assets under management
had signed the PRI, representing over 10% of total assets worldwide. Responsible investing represents
$3.1 trillion of all assets under management, or one-eighth of all dollars under professional
management in the United States.28
29
27
"Principles for Responsible Investment." Introducing Responsible Investment. Principles for Responsible Investment. Web. 5 Dec. 2012. 28
"Economically Targeted Investing: Capitalizing on Opportunities in Emerging Domestic Markets." RBCGAM.com. RBC Global Asset Management, 2010. Web. 8 Dec. 2012. 29
"Glossary." Luminis Microfinance. MicroRate. Web. 2 Dec. 2012.
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There are two subcategories of responsible investing: Socially Responsible Investing and impact investing.
Socially Responsible Investing (SRI) is the largest segment of responsible investment. SRI
investments are made in for-profit companies selected via the use of a screening strategy. A positive
screening strategy selects investments that are deemed to have “best-in-class” ESG measures. An
exclusion screening strategy filters out companies that are considered to promote harmful societal
outcomes, such as the alcohol, tobacco, gambling, and armament industries, or do business with
oppressive regimes.30 The SRI approach is best summarized as a “do no harm” approach. SRI is focused
primarily on maximizing investment returns, combined with assurance that the investments are not
negatively affecting the society.
Impact investing is intended to create maximal societal impact along with a financial return to
the investor.31 Impact investing is the fastest-growing segment of responsible investing. Impact investing
worldwide is expected to grow from $50 billion in 2009 to $500 billion by 2019.32 Impact investing
includes community investing, mission-related investing (MRI), and economically targeted investment
(ETI). On a global level, impact investing also includes investment in microfinance and other social
businesses.
Economically targeted investment (ETI): investments made with the intended purpose of
achieving competitive financial returns while assisting in the development of geographically
targeted economies.33
Community investing: investing in disadvantaged communities nationwide via community
development financial institutions (CDFIs) and other financial organizations. CDFIs target
30
"European Responsible Investing Fund Survey." 31
“Glossary.” 32
"Investing for Social & Environmental Impact." Monitorinstitute.com. Monitor Institute, 2009. Web. 1 Dec. 2012. 33
"California Public Employees' Retirement System Statement of Investment Policy."Calpers.ca.gov. CalPERS, 17 Feb. 2009. Web. 5 Dec. 2012.
Responsible Investing
"Do no harm"
Socially Responsible Investing
Active Screening
Passive Screening
"Do good"
Impact Investing
Community Investing
Mission-Related Investing
Economically Targeted Investing
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economically distressed and underserved markets in the United States and seek to create
positive societal impact while generating a moderate level of profit. 34
Mission-related investing (MRI), (a/k/a mission-driven investing and program-related investing):
the investing of non-profit endowments in a way that complements their mission by focusing
the investments on the non-profit’s targeted impact area and geography. Depending on a non-
profit’s funding needs, mission-related investing can prioritize either societal impact or financial
return.35
Economically targeted investing (ETI) is often used interchangeably to refer to community
investing and mission-related investing. While there are marked differences between the three
concepts, they are similar in their focus on specific underserved geographic regions. In 2010, $38 billion
was invested in geographically targeted U.S.-based funds.36
Economically Targeted Investments
ETIs are investments made in specific geographic regions with the goal of creating economic
growth and improving the local quality of life. They follow a Double Bottom Line strategy (investments
with market rates of financial return and measurable economic and social impact) or a Triple Bottom
Line strategy, which also consider environmental externalities as part of the decision process.37
The areas targeted by ETI are frequently referred to as “domestic emerging markets,” a term
created by the Milken Institute in the late 1990s. Emerging domestic markets (EDMs) are geographical
areas that have suffered from capital shortages due to imperfect market information and the lack of
effective financial institutions.38 EDMs are generally characterized by large populations of racial and
ethnic minorities – who account for 91.7% of the United States’ population growth over between 2000
and 2010.39 The combination of America’s African American and Hispanic consumer markets is larger
than the GDP of all but nine countries in the world.40 This population growth is driving the creation of
minority-owned businesses. Between 1997 and 2002, the number of firms owned by African-Americans,
34
"CDFI Fund." CDFI Fund. U.S. Treasury, 2 Oct. 2012. Web. 3 Dec. 2012.> 35
"Mission-Related Investing for Foundations and Non-Profit Organizations." CDFI Fund. Trillium Asset Management Corporation, 2007. Web. 4 Dec. 2012. 36 “Economically Targeted Investing.” 37 "Overview of Economically Targeted Investments." Lacers.org. Los Angeles City Employees' Retirement System, 27 Nov. 2012. Web. 4 Dec. 2012. 38 “Economically Targeted Investing;” "Filling "Institutional Voids" in Emerging Markets." Forbes. Forbes Magazine, 20 Sept. 2011. Web. 4 Dec. 2012. 39 "Minorities Account for Nearly All U.S. Population Growth." PewResearch.org. Pew Research Center, 30 Mar. 2011. Web. 5 Dec. 2012. 40
Humphreys, Jeffrey M. "The Multicultural Economy, 2006." Georgia Business and Economic Conditions 66.6 (2006). Print.
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Hispanics, and Asian-Americans grew at 5.6% annually, or nearly three times faster than the rate of all
firms.41 Minority women-owned firms grew at even faster rate of 9.9%.
Emerging domestic markets include ethnic and women-owned firms, urban and rural
communities, companies serving the low- and moderate-income populations, and other small- and
medium-sized businesses.42 More than 74% of small businesses report doing some or all of their
businesses locally, with 36% stating that most of their customers are local.43 The majority businesses in
EDMs are underserved by capital markets, creating a capital shortage that hinders their growth – and
therefore, the growth of the local and national economies. First, the lack of credit information about
businesses in EDMs has perpetuated the misperception that they are small, unprofitable, and
unfavorably located.44 Second, businesses in EDMs lack collateral and are unable to access sources of
alternative financing. As a consequence, they are forced to rely on commercial bank lending, which has
become tougher to access as a consequence of increased regulation, the tightening of credit terms since
the recession, and bank consolidations.45
Small businesses are commonly regarded as job creators and the drivers of long-term economic
growth.46 These firms increase employment at an average of 3% per year, in comparison to the 1.8%
nationwide growth in employment.47 The lack of credit is the most significant problem for small
businesses; in an October 2012 study by the Association for Enterprise Opportunity, 58% of small
businesses regarded the availability of credit as a serious problem for their business.48 With the average
small business owner requiring a total of $47,535 in external financing, the total small business funding
gap in the United States was estimated at $300 billion.49 As a result, the ability to obtain additional
funding is crucial to small business owners. By targeting EDMs, ETI can address the funding gap
experienced by small businesses.
41
Yago, Glenn, Betsy Zeidman, and Alethea Abuyman. "Emerging Domestic Markets."Community Development Investment Review. Federal Reserve Bank of San Francisco, June 2007. Web. 15 Dec. 2012. 42 Yago, Zeidman et al. 43 "Opinion Poll: The Role of Micro Businesses in Our Economy." Small Business Majority. Association for Enterprise Opportunity, 9 Oct. 2012. Web. 12 Dec. 2012. 44
Yago, Glenn, and Michael Harrington. "Mainstreaming Minority Business: Financing Domestic Emerging Markets." MilkenInstitute.org. Milken Institute, Feb. 1999. Web. 4 Dec. 2012. 45 Yago and Harrington. 46 "What Is SBA's Definition of a Small Business Concern?" SBA.gov. Small Business Administration. Web. 7 Dec. 2012. 47 "Business Dynamics Statistics." Business Dynamics Statistics. Kauffman Foundation. Web. 17 Dec. 2012. 48 “Opinion Poll.” 49 "How Crowdfunding Fills the Small Business Funding Gap." Localstake.com. Localstake, July 2012. Web. 4 Dec. 2012.
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50
50
"Sustainable and Responsible Investing Trends in the United States 2012." US SIF. The Forum for Sustainable and Responsible Investment, 2012. Web. 8 Dec. 2012.
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Types of Economically Targeted Investments (ETI)51
Typ
e
Strategy Methods Societal Impact
Equ
ity
Funding business growth for industries with a competitive advantage that operate in underserved communities and/or owned by minority entrepreneurs
Private Equity Venture capital Mezzanine capital Company buy-outs
Improved access to goods Reduced cost of living Job creation Increased economic growth
Re
al e
stat
e d
eve
lop
me
nt
Investing in real estate development firms that are involved in the construction or redevelopment of: office space industrial buildings low-/mid-income housing
Debt Equity
Influence long-term development plans and transportation strategies Reduce cost of living by addressing shortages in real estate market Increase value of local real estate Job creation Increased economic growth
Direct investing in rental properties, office or commercial space
Equity (Same as above)
Investing in local real estate investment trusts Equity Address shortages in real estate market Increase value of local real estate Job creation Increased economic growth
Invest in mortgage-backed securities that fund home ownership for underserved market
Debt Reduce cost of home ownership in underserved communities
Fixe
d in
com
e
secu
riti
es
Underwriting projects that provide essential services in underserved areas such as: home ownership healthcare education
Subord. debt Reduce the cost of project financing Improve access to services Reduce cost of living Job creation Increased economic growth
Buy municipal bonds (general obligation or revenue)
Municipal debt (Same as above)
Buy bonds guaranteed by third parties such as the Small Business Administration
Debt (Same as above)
Infr
astr
uct
ure
pro
ject
s Invest in infrastructure projects that would stimulate or facilitate regional economic growth, such as: transportation educational institutions public works healthcare facilities
Municipal or commercial debt Subord. debt Equity
Improve access to public services and basic goods Reduce cost of living Job creation Increased economic growth
Underwrite bonds for infrastructure projects Subord. debt (Same as above)
Cre
dit
en
han
cem
en
ts Guarantee third-party loans made to
businesses and service providers essential to the community
Subord. debt Improve access to credit for local firms and households Reduce cost of capital Job creation Increased economic growth
Guarantee loans for well-qualified borrowers in underserved neighborhoods Collateralized mortgage obligations Mortgage-backed securities
Debt Address “red-lining,” or the denial of loan applications based on a neighborhood’s characteristics, rather than an applicant’s creditworthiness Improve access to credit Increase regional investment
51
“Economically Targeted Investing;” “Overview of Economically Targeted Investments.”
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Characteristics of ETI
The table on the previous page summarizes the various investment strategies possible in an ETI
portfolio. It should be noted that real estate investments are the least liquid type of investment possible
with an ETI strategy. However, a sufficiently large real estate development can have a significant effect
on shaping the future economic environment in an area. Furthermore, as a real asset, real estate
investment can help provide a diversification effect against inflation in the context of an overall portfolio.
As a consequence of investing in developing economic areas, ETI investments are less liquid than
traditional investments in the same asset classes, which may be diversified on a nationwide or even
global level. The emerging domestic markets (EDMs) targeted by ETIs exhibit lower levels of integration
with the national and global economies. As a result, ETI returns may vary considerably depending on the
conditions of the local economy. As a result, ETIs may present both diversification benefits (due to
imperfect correlation with broad equity markets), as well as the likelihood of above-average volatility
(due to greater geographic concentration).
Due to the smaller scale of investments and the need to monitor societal impact, management
and due diligence expenses for ETIs is generally greater than similar traditional investments. However,
as a consequence of underinvestment in EDMs resulting in high demand for capital, ETIs are also likely
to have above-market levels of financial returns. As the risks and returns of ETIs are highly dependent on
local factors, the investment manager must have considerable knowledge of the local economy.
Ultimately, ETIs may present attractive risk-adjusted returns and diversification benefits – but it is
necessary to take their relative illiquidity, greater volatility, and higher management costs into account.
Investors in ETI
ETI attracts a variety of institutional and private investors, including commercial banks, pension
funds, corporations and insurance companies, foundations and endowments, and individuals.
Commercial banks are the largest players in the ETI space – partly due to the requirements of the
Community Reinvestment Act of 1977, which requires banks to reinvest a certain percentage of their
assets in low-income areas.52 Commercial banks make ETIs with the goals of maximizing their financial
returns, as well as increasing their local customer base.53 U.S.-based pension funds are the second
largest class of investors in ETI. Pension funds invest in ETIs for the diversification benefits, and union
pension funds invest in communities where their members live and work. Corporations, particularly
insurance companies, seek both financial and societal returns, and seek maximal return on investment,
diversification benefits, and development of new markets. For instance, Impact Community Capital, LLC
52
White, Lawrence J. "The Community Reinvestment Act: Good Goals, Flawed Concept."Federal Reserve Bank of San Francisco. Stern School of Business, New York University, 2009. Web. 13 Dec. 2012. 53 “Economically Targeted Investing;” “Overview of Economically Targeted Investments.”
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is a joint venture owned by the eight major insurance companies active in California (representing $22
billion in annual premiums), that manages ETI investments for the companies. Corporations also use ETIs
to supplement their ESG goals. Foundations and endowments resort to ETIs in order to maximize their
social impact, and focus on causes related to their mission statements.54 Universities frequently invest
portions of their endowment locally in order to improve student services, as well as improving
relationships with the local population.55 For instance, Brown University measures the direct, indirect
and induced impacts of its spending, as well as investing a portion of its endowment portfolio in ETIs.56
Finally, ETIs are gaining popularity with high-net-worth individuals, who may be attracted to ETI for the
high returns, the diversification benefits, or the promise of societal impact.57 ETIs are attractive to a
wide variety of investors due to the possibilities of selecting among a variety of asset classes to achieve
particular levels of financial and societal returns.
Benefits of ETI
ETIs concentrate the economic and investment benefits in a particular geographic region. This
creates local jobs, improves the local economy, and the overall quality of life in the region. Furthermore,
investments in local real estate development may boost the value of real estate in the area. Pension
funds may be able to make ETIs that support their members’ livelihoods or communities. For instance, a
union pension fund may choose to reinvest some of its money into its workers’ firms, while members of
a fire department might prioritize investments in their home town. Finally, for government-sponsored
investments (such as pension funds for government employees), ETIs have the additional benefit of
expanding the tax base – which creates a multiplier effect for local tax revenues.58
Among all of the types of investors in ETI, pension funds have the greatest potential return from
increasing their allocation to ETI. As of 2008, 21 states used their pension funds to make in-state
economically targeted investments.59 Due to the large size of their portfolios – which in 2011 exceeded
$16 trillion, or 107% of U.S. GDP60 – pension funds are capable of creating massive societal impacts via
increasing allocation to ETIs. Most public pension funds with an ETI component allocate approximately
54 Yago, Zeidman et al. 55 Sauchik, Alec. "Fordham Urban Law Journal." Beyond Economically Targeted Investments: Redefining the Legal Framework. Fordham Urban Law Journal, 2000. Web. 17 Dec. 2012. 56
"The Brown University Endowment: Investing in Brown’s Future." Brown.edu. Brown University, 2007. Web. 16 Dec. 2012. 57 “Overview of Economically Targeted Investments.” 58 “Overview of Economically Targeted Investments.” 59
"Economically Targeted Investment Program Under Development." Office of Program Policy Analysis and Government Accountability, Dec. 2008. Web. 12 Dec. 2012. 60 "Global Pension Assets Study 2012." TowersWatson.com. Towers Watson, Jan. 2012. Web. 5 Dec. 2012.
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2% of its portfolio to ETIs; the majority of these funds are invested in residential housing and other real
estate.61
A Selection of Public Pension Funds Engaged in ETI Fund Name Total Fund
Size ($) ETI
Inception ETI
Allocation Asset Classes
CalPERS $239 billion 2002 2% target Private Equity, Real Estate, Mortgage Loans
CalSTRS $155 billion 2002 2% target Private Equity, Real Estate, Mortgage Loans
Florida Growth Fund
$155 billion 2008 1.5% target Venture and Growth Capital, Infrastructure Sector Funds, Co-Investments, Merchant Banking62
NYCERS $151 billion 2003 $500 million Real Estate/Residential Housing, Housing Investment Trusts
Effects of Pension Fund Regulation
While public pension funds stand the most to benefit from ETI due to their large size, they are
subject to government regulation that restricts their ability to select economically targeted investments.
In their investment selection process, public pension funds must comply with the federal regulations of
the Employee Retirement Income Security Act of 1974 (ERISA). ERISA, which is enforced by the U.S.
Department of Labor’s Employee Benefits Security Administration (EBSA), requires employers who
establish pension plans to meet certain minimum standards, including the reporting of plan information;
minimum standards for vesting, benefit accrual and funding; the accountability of plan fiduciaries; and
the rights of pension plan participants to sue for breaches of fiduciary duty.63 ERISA requires that
pension funds diversify their investments across a variety of investment classes in order to bring
portfolios in line with modern investment guidelines.64 Two recently released ERISA bulletins, which
explain EBSA’s current interpretation of the ERISA law, are of particular importance to economically
targeted investments.:
61 Hoffer, Doug. "A Survey of Economically Targeted Investments: Opportunities for Public Pension Funds." Publicassets.org. Public Assets Institute, 16 Feb. 2004. Web. 1 Dec. 2012. 62 "Economically Targeted Investment Program Under Development." 63
"The Employee Retirement Income Security Act (ERISA)." Department of Labor. United States Department of Labor. Web. 17 Dec. 2012. 64 Sauchik, Alec.
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The ERISA Interpretive Bulletin §2509.08-1 specified EBSA’s position on ETIs by emphasizing that
a fiduciary is required to act “solely in the interest …and for the exclusive purpose of providing benefits
[to the plan’s] participants and beneficiaries” and that “fiduciaries may never subordinate the economic
interests of the plan to unrelated objectives.”65 This bulletin, known as the “Rigid Rule,” mandates
investment managers to consider the diversification, liquidity, and potential risk/return of alternative
investments under consideration with available traditional investments, and to make decisions that
maximize the expected risk-adjusted return to the portfolio. Non-financial impact may only be
considered in circumstances where the financial returns of multiple investments are equal.66 As a
consequence, economically targeted investments may only be made when the fiduciaries are able to
demonstrate that the ETIs have equal or superior financial return.
The ERISA Interpretive Bulletin §2509.08-2 warned investment managers against using proxy
votes in order to further policy goals such as social impact, stating that “a fiduciary shall consider only
factors that relate to the economic interest of participants and their beneficiaries in plan assets, and
shall not use an investment policy to promote myriad public policy preferences.”67 This bulletin requires
fiduciaries to have evidence that its proxy voting, investment policies, or due diligence activities have
the goal of maximizing financial returns of a portfolio.
As a consequence of the aforementioned ERISA Bulletins, investment managers of pension
funds must prioritize financial returns on investments before considering non-financial externalities.
ERISA regulations prohibit the selection of investments based on their societal impact alone if they do
not lead to the maximization of risk-adjusted returns.
It must be noted, however, that ERISA regulations do not apply to non-pension fund investment
portfolios. Non-profit organizations, corporations, banks, and individuals are able to select ETIs without
having to demonstrate maximal risk-adjusted returns. As a consequence, investors who are not required
to comply with ERISA regulations should take care to achieve their desired societal impact without
reducing the investment’s financial return. While it is theoretically possible to maximize societal impact
without sacrificing financial return, the evidence presented by a number of studies on the effectiveness
of various responsible investments is largely conflicting.68
65 "ERISA Interpretive Bulletin §2509.08-1." GPO.gov. U.S. Government Printing Office, 17 Oct. 2008. Web. 8 Dec. 2012. 66 Ibid. 67
"Interpretive Bulletin 29 CFR 2509.08-2." Legal Information Institute. Cornell University Law School, 17 Oct. 2008. Web. 8 Dec. 2012. 68
“Investing for Impact.”
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Previous Investment Losses in ETI Portfolios
Several early implementations of ETI principles experienced significant losses on their investments.
In the early 1980s, Pennsylvania’s state and teacher pension fund lost $40 million of their $70
million investment in an in-state Volkswagen plant which declared bankruptcy. The decision was
not based on risk-adjusted returns.69
Over the course of the 1980s, the Kansas Public Employees Retirement System invested $400
million into various Kansas-based companies, including a $65 million investment in Kansas
Savings and Loan Bank. The fund later lost $236 million of the investment, including the entirety
of its Savings and Loan stake, with the failure attributed to the fund manager’s lack of relevant
skills and experience.70
In 1990, the Connecticut Retirement and Trust Funds acquired 47% of the Colt’s Manufacturing
Company, a firearms manufacturer, for $25 million in order to help save 1,000 jobs at its plant.
The company filed for bankruptcy in 1993 as a consequence of high capital expenditures and
low sales, causing the state to lose $20 million.71 State officials decided to invest in the company
for political reasons and without adequately considering the investment’s risk-adjusted returns.
In the majority of previous cases in which ETI investments experienced significant losses, the
losses happened due to errors in judgment, such as political interference, insufficient diversification, or
inadequate skill of the investment managers.72 Furthermore, most significant losses occurred in venture
capital investments – which involve a significant amount of risk. Since then, investors in ETIs have
significantly improved their risk management capabilities, as seen by the number and asset value of
existing programs.
69 Houffer, Doug. 70 Ibid. 71
Stevenson, Richard W. "Pension Funds Becoming a Tool for Growth." The New York Times. The New York Times, 17 Mar. 1992. Web. 16 Dec. 2012. 72 Hoffer, Doug.
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Conclusion
Economically targeted investment (ETI) is an approach to investing that seeks to provide maximized risk-
adjusted financial returns by investing in emerging domestic markets, or domestic regions underserved
by financial institutions. While ETIs are less liquid than traditional equity or debt investments due to
their focus on underserved geographies, they may have distinct benefits in a portfolio context, such as
low correlation with financial markets, diversification, and high risk-adjusted financial returns. By
providing capital to underserved communities, ETIs improve social and economic welfare of a region,
create jobs, and fuel economic growth. ETIs may be appropriate for a variety of investors’ portfolios,
including banks, corporations, non-profits and endowments, private investors, and others who seek to
both benefit society and receive competitive rates of financial return. While pension plans have a large
capital base which they could use to create significant societal impact nationwide, regulation designed
to protect shareholders of pension plans restricts the ability of pension fiduciaries from investing in ETIs
unless they offer demonstrably superior financial returns. ETIs can present considerable benefits to a
variety of investors; however, investors should take care to achieve their desired levels of societal
returns without affecting their financial return on investment.
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