An Introduction to Purpose-Driven Investing

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Back in 2023, I went out to lunch with one of my first clients, a successful technology entrepreneur. After catching up about the markets, his business, and other professional topics, we somehow ended up at the question of purpose. I ended up asking him - how do you think about purpose? Are there any causes or initiatives that you want to support with your wealth?

And I still remember his answer vividly. He told me that he often found himself talking to fellow affluent individuals who hadn’t made their money in tech, but with a traditional German Mittelstand business. Often, it wasn’t them, but their parents or grandparents who had founded the business decades ago far away from buzzy towns like Munich or Berlin, which ended up growing into a highly specialized company with thousands of employees. Just by being there, keeping the company going through its highs and lows, keeping well-paid jobs in Germany and not moving them abroad, and perhaps even supporting the local soccer club (or similar initiatives), he saw his peers find their purpose in responsible entrepreneurship. My interactions with individuals from such entrepreneurial dynasties, to the most part, support this view as well.

But he found himself in quite a different situation. He had started a tech business, grew it to about a hundred employees, sold it within five years, and ended up leaving after the integration process. No more responsibility for his employees (in the positive and negative sense), no new project lined up. He wanted to do well, use some of his wealth for good causes, ‘pay it forward’ - but at that point in time, he didn’t have purpose for himself yet.

Since then, I’ve had many such discussions with affluent individuals. Some found their purpose. But many more are still searching. With Cape May, we try hard to help our clients find that purpose. Typically, we come in once they’ve found it - and look for our assistance in reflecting that purpose in their investment portfolios.

A Framework for Purpose

If one thing is clear from those many discussions, it’s that almost every individual has a different view of what purpose is for them.

The most frequent notion surrounds approaches such as ‘ESG’ (Environmental, Social, and Governance) or Impact Investing (investments with a positive non-financial impact, but also a clear intention to generate profits). But purpose is often also more philosophical in nature. For example, one individual we worked with actively told us that he saw ESG and similar frameworks as ‘greenwashing’. But they had made their money in a creative industry and clearly saw it as their purpose to keep on investing in that industry, especially in Germany. Yet another client didn’t want any part of his portfolio to be purpose-oriented, but was looking to donate a substantial amount of his excess gains to charitable causes (see Effective Altruism).

But regardless of what your final purpose is, how should your holistic framework of applying said purpose look like? In prior discussions with clients, we like to categorize investments in a framework like the following:

We’ll go into more detail for all of those categories, but let’s first define what we mean with them:

Screened & Indexed Investments: Your typical ‘ESG-screened’ ETF or investment portfolio. Within an entire purpose-driven portfolio, such investments likely make up the largest part, for example in the form of liquid assets within your Market Bucket. 

Impact Investing: While screened / indexed investments are the ‘core’ of your Market Bucket, Impact Investing is typically the ‘satellite’. They are investments that clearly look to generate competitive returns, but also aim to contribute a positive impact in-line with your specific purpose.

Venture Philanthropy: Supporting individual, specific causes through individual venture and venture-like investments aimed at said cause. This part of the portfolio is typically not return-oriented like impact investing, but clients would like to see companies be self-sustaining at some point, giving them the chance to at least receive some of their money back.

Charitable Giving: Support individual, specific causes through one-off or ongoing donations. Charitable Giving typically wants to see a tangible ‘return’ in regards to its good cause, but individuals don’t expect any financial return, except the tax write-off that comes with it.

We’d also make some careful generalizations, as we move from screened & indexed investments to impact investing to venture philanthropy and charitable giving (‘top to bottom’):

• The more you move from top to bottom, the more risky your investments become - as is in the nature of any more concentrated, topic-focused investment.
  

• The more you move from top to bottom, the more focused you can be on your purpose goal - a venture investment can be extremely targeted to an individual cause, a screened ETF likely less so.

• The more you move from top to bottom, the higher your expected return - whether that is financial or in terms of generating impact in regards to your desired purpose.

So with that in mind, let’s get into more detail.

Screened & Indexed Investments

As mentioned in the prior section, screened investments are most applicable to a diversified liquid portfolio. Starting with a very diversified index such as an MSCI World, investors can use index solutions to filter and segment a given index according to their preferences, ending up at the portfolio which they deem to be most fitting to their purpose. 

If the assets you are managing are sizeable enough to go into the direction of direct indexing and/or active management - for example, a bank constructing and managing a portfolio according to your respective purpose -, there’s no limit to what can be done. However, if you are looking to use index funds and ETFs, there might not be a sufficiently liquid and/or properly designed instrument available for every index. In prior discussions with clients who see their purpose in climate-related topics, we’ve deemed the following indices as properly investable:

Exclusions for a given index show the sectors and industries that the respective index provider is looking to limit or exclude entirely. For example, the S&P Net Zero 2050 Paris-Aligned Index excludes industries with a negative environmental impact, such as oil & gas. Additions are additional factors that come into play in index design. For example, the Bloomberg MSCI SRI Bond Index further limits the scope of companies by only including those in the top half of ESG ratings, while the MSCI ESG Enhanced only excludes companies that produce below-average emissions that also look to decrease them over time.

In this regard, also a note on the topic of index design: Any screening or indexing method will to some degree be imperfect, with some companies becoming rightful points of debate on whether they should be in the index or not. The most common example is likely Tesla - the company is a clear pioneer in the electric vehicle industry, but also has what one might kindly call a spotty track record in corporate governance. In the end, any of the popular indices will likely have more than one ‘unwanted’ company in it. If that is an issue to you, you might have to move away from indexing to an actively managed strategy.

Which also gets us to the most important topic - index deviation. Any screened or indexed investment typically reduces (and not increases) the number of companies in an index. The more strict an index, the more its long-term performance fill fluctuate relative to the performance of the unscreened index, with consequences to its performance and risk profile.

Take the aforementioned sustainability-focused indices. They were underweight ‘out of favor’ oil and gas producers, and overweight fast-growing companies in the renewable energy space. But given their tilt, they also added weight to the already highly-weighted tech stocks, which to the most part screen well in ESG indices. As a result, sustainability-focused indices performed tremendously well in years such as 2020 and 2021, but fell behind the wider index in subsequent years. This so-called tracking error (how much does your investment deviate from its benchmark over time) is a long-term risk that purpose-oriented investors should keep in mind. Take the S&P Net Zero 2050 Paris-Aligned Index, where we expect an index deviation of 2-3% per year - if we expect the worst case of a long-term index deviation moving against you, it might have significant impact on your long-term return goals. For client portfolios at Cape May, we add an adequate ‘safety puffer’ in the form of an expected performance discount.

But is that really likely? Shouldn’t a megatrend such as renewable energy not lead to higher returns, given the massive demand?

I would personally think so, given the massive opportunity set to decarbonize our economy. But there might also be an academic argument against it. If we take an out-of-favor investment such as a coal-fired power plant, we’d expect their cost of capital to go up as less investors line up to finance them - with the opposite being true for a ‘favored’ investment such as solar, which becomes cheaper to finance. However, what we need to be mindful of is the other side, meaning the investors: Lower capital costs for a company logically result in lower returns for the party providing the returns, and by that logic, we’d achieve a higher return by financing not solar, but coal power plants. (In this regard, I recommend a recent podcast by Capital Allocators with an energy PE fund playing both conventional and renewable energy investments.)

Getting More Specific: Impact Investing & Philanthropy

As mentioned in my last paragraph, indexed investments can be a great way for investors to broadly align their investment portfolio with their individual purpose. But they will never be the perfect solution, given the difficulty, if not impossibility, to build a perfect indexed solution - to achieve that, we have to move away from a generalized, indexed solution, towards something more akin to active management.

Which brings us to our next section, impact investing, and ultimately, venture philanthropy and charitable giving. As we explained before, both try to find solutions to specific causes aligned with an individual’s purpose, but with a differing degree of profit orientation: While impact investing is clearly looking to generate profit, venture philanthropy might look to generate a small return (or at least see the invested capital returned), while outright philanthropy is happy to simply give money to a good cause.

How do they work? What challenges have we at Cape May experienced with such investments? More on that in next week’s newsletter.

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