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Strategy 1: value investing, strategy 2: growth investing, strategy 3: momentum investing, strategy 4: dollar-cost averaging.

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The Bottom Line

4 key investment strategies to learn before trading.

Choose a strategy that fits your profit objectives and skills

An investment strategy is a set of principles that guide investment decisions. There are several different investing plans you can follow depending on your risk tolerance, investing style, long-term financial goals, and access to capital,

Investing strategies are flexible. If you choose one and it doesn’t suit your risk tolerance or schedule, you can certainly make changes. However, changing investment strategies come at a cost. Each time you buy or sell securities—especially in the short-term in non-sheltered accounts—may create taxable events. You may also realize your portfolio is riskier than you'd prefer after your investments have dropped in value.

Here, we look at four common investing strategies that suit most investors . By taking the time to understand the characteristics of each, you will be in a better position to choose one that’s right for you over the long term without the need to incur the expense of changing course.

Key Takeaways

• Before you figure out your strategy, take some notes about your financial situation and goals.
• Value investing requires investors to remain in it for the long term and to apply effort and research to their stock selection.
• Investors who follow growth strategies should be watchful of executive teams and news about the economy.
• Momentum investors buy stocks experiencing an uptrend and may choose to short sell those securities.
• Dollar-cost averaging is the practice of making regular investments in the market over time.

Before you begin to research your investment strategy , it's important to gather some basic information about your financial situation. Ask yourself these key questions:

• What is your current financial situation?
• What is your cost of living including monthly expenses and debts?
• How much can you afford to invest—both initially and on an ongoing basis?

Even though you don't need a lot of money to get started, you shouldn't start investing until you can afford to do so. If you have debts or other obligations, consider the impact investing will have on your short-term cash flow before you start putting money into your portfolio.

Make sure you can afford to invest before you actually start putting money away. Prioritize your current obligations before setting money aside for the future.

Next, set out your goals. Everyone has different needs, so you should determine what yours are. Are you saving for retirement ? Are you looking to make big purchases like a home or car in the future? Are you saving for your or your children's education? This will help you narrow down a strategy as different investment approaches have different levels of liquidity, opportunity, and risk.

Next, figure out what your risk tolerance is. Your risk tolerance is determined by two things. First, this is normally determined by several key factors including your age, income, and how long you have until you retire. Investors who are younger have time on their side to recuperate losses, so it's often recommended that younger investors hold more risk than those who are older.

Risk tolerance is also a highly-psychological aspect to investing largely determined by your emotions. How would you feel if your investments dropped 30% overnight? How would you react if your portfolio is worth $1,000 less today than yesterday? Sometimes, the best strategy for making money makes people emotionally uncomfortable. If you're constantly worrying about the state of possibly losing money, chances are your portfolio has too much risk.

Risk-Reward Relationship

Risk isn't necessarily bad in investing. Higher risk investments are often rewarded with higher returns. While lower risk investments are more likely to preserve their value, they also don't have the upside potential.

Finally, learn the basics of investing. Learn how to read stock charts, and begin by picking some of your favorite companies and analyzing their financial statements. Keep in touch with recent news about industries you're interested in investing in. It's a good idea to have a basic understanding of what you're getting into so you're not investing blindly.

Value investors are bargain shoppers. They seek stocks they believe are undervalued. They look for stocks with prices they believe don’t fully reflect the intrinsic value of the security. Value investing is predicated, in part, on the idea that some degree of irrationality exists in the market. This irrationality, in theory, presents opportunities to get a stock at a discounted price and make money from it .

It’s not necessary for value investors to comb through volumes of financial data to find deals. Thousands of value mutual funds give investors the chance to own a basket of stocks thought to be undervalued. The Russell 1000 Value Index , for example, is a popular benchmark for value investors and several mutual funds mimic this index.

For those who don’t have time to perform exhaustive research, the price-earnings ratio (P/E) has become the primary tool for quickly identifying undervalued or cheap stocks. This is a single number that comes from dividing a stock’s share price by its earnings per share (EPS). A lower P/E ratio signifies you’re paying less per $1 of current earnings. Value investors seek companies with a low P/E ratio.

Who Should Use Value Investing?

Value investing is best for investors looking to hold their securities long-term. If you're investing in value companies, it may take years (or longer) for their businesses to scale. Value investing focuses on the big picture and often attempts to approach investing with a gradual growth mindset.

People often cite legendary investor Warren Buffett as the epitome of a value investor. Consider Buffett’s words when he made a substantial investment in the airline industry . He explained that airlines "had a bad first century." Then he said, "And they got that century out of the way, I hope." This thinking exemplifies much of the value investing approach: choices are based on decades of trends and with decades of future performance in mind.

Over the long-run, value investing has produced superior returns. However, value investing has seen prolonged periods where it has underperformed growth investing. One study from Dodge & Cox determined that value strategies have lagged behind growth strategies for a 10-year period during three periods over the last 90 years. Those periods were the Great Depression (1929-1939/40), the Technology Stock Bubble (1989-1999), and the period 2004-2014/15. Indeed, value investing, has consistently underperformed growth investing since 2007, producing a drawdown of more than 50% through 2020. It remains to be seen whether value stocks will regain their luster in the near future.

Pros and Cons - Value Investing

There's long-term opportunity for large gains as the market fully realizes a value company's true intrinsic value.

Value companies often have stronger risk/reward relationships.

Value investing is rooted in fundamental analysis and often supported by financial metrics.

Value companies are more likely to issue dividends as they aren't as reliant on cash for growth.

Value companies are often hard to find especially considering how earnings can be inflated due to accounting practices.

Successful value investments take time, and investors must be more patient.

Even after holding long-term, there's no guarantee of success - the company may even be in worse shape than before.

Investing only in sectors that are underperforming decreases your portfolio's diversification.

Rather than look for low-cost deals, growth investors want investments that offer strong upside potential when it comes to the future earnings of stocks. It could be said that a growth investor is often looking for the “next big thing.” Growth investing, however, is not a reckless embrace of speculative investing . Rather, it involves evaluating a stock’s current health as well as its potential to grow.

A drawback to growth investing is a lack of dividends . If a company is in growth mode, it often needs capital to sustain its expansion. This doesn’t leave much (or any) cash left for dividend payments. Moreover, with faster earnings growth comes higher valuations, which are, for most investors, a higher risk proposition.

While there is no definitive list of hard metrics to guide a growth strategy, there are a few factors an investor should consider. Growth stocks do tend to outperform during periods of falling interest rates, as newer companies can find it less expensive to borrow in order to fuel innovation and expansion. It's important to keep in mind, however, that at the first sign of a downturn in the economy, growth stocks are often the first to get hit.

Growth investors also need to carefully consider the management prowess of a business’s executive team . Achieving growth is among the most difficult challenges for a firm. Therefore, a stellar leadership team is required. At the same time, investors should evaluate the competition. A company may enjoy stellar growth, but if its primary product is easily replicated, the long-term prospects are dim.

Who Should Use Growth Investing?

Growth investing is inherently riskier and generally only thrives during certain economic conditions. Investors looking for shorter investing horizons with greater potential than value companies are best suited for growth investing. Growth investing is also ideal for investors that are not concerned with investment cashflow or dividends.

According to a study from New York University’s Stern School of Business, “While growth investing underperforms value investing, especially over long time periods, it is also true that there are sub-periods, where growth investing dominates.” The challenge, of course, is determining when these “sub-periods” will occur. While it's inadvisable to try and time the market, growth investing is most suitable for investors who believe strong market conditions lay ahead.

Because growth companies are generally smaller and younger with less market presence, they are more likely to go bankrupt than value companies. It could be argued that growth investing is better for investors with greater disposable income as there is greater downside for the loss of capital compared to other investing strategies.

Pros and Cons - Growth Investing

Growth stocks and funds aim for shorter-term capital appreciation. If you make profits, it'll usually be quicker than compared to value stocks.

Once growth companies begin to grow, they often experience the sharpest and greatest stock price increases.

Growth investing doesn't rely as heavily on technical analysis and can be easier to begin investing in.

Growth companies can often be boosted by momentum; once growth begins, future periods of continued growth (and stock appreciation) are more likely.

Growth stocks are often more volatile. Good times are good, but if a company isn't growing, its stock price will suffer.

Depending on macroeconomic conditions, growth stocks may be long-term holds. For example, increasing interest rates works against growth companies.

Growth companies rely on capital for expansion, so don't expect dividends.

Growth companies often trade at high multiple of earnings; entry into growth stocks may be higher than entry into other types of stocks.

Momentum investors ride the wave. They believe winners keep winning and losers keep losing. They look to buy stocks experiencing an uptrend. Because they believe losers continue to drop, they may choose to short-sell those securities.

Momentum investors are heavily reliant on technical analysts . They use a strictly data-driven approach to trading and look for patterns in stock prices to guide their purchasing decisions. This adds additional weight to how a security has been trading in the short term.

Momentum investors act in defiance of the efficient-market hypothesis (EMH). This hypothesis states that asset prices fully reflect all information available to the public. A momentum investor believes that given all the publicly-disclosed information, there are still material short-term price movements to happen as the markets aren't fully recognizing recent changes to the company.

Despite some of its shortcomings, momentum investing has its appeal. Consider, for example, that The MSCI World Momentum Index, which has averaged annual gains of 10.75% since its inception (in 1994) through June 2022, compared to 7.59% for its benchmark over the same period.

Who Should Use Momentum Investing?

Traders who adhere to a momentum strategy need to be at the switch, and ready to buy and sell at all times. Profits build over months, not years. This is in contrast to simple buy-and-hold strategies that take a "set it and forget it" approach.

In addition to being heavily active with trading, momentum investing often calls for continual technical analysis. Momentum investing relies on data for proper entry and exit points, and these points are continually changing based on market sentiment. For those will little interest in watching the market every day, there are momentum-style exchange-traded funds (ETFs).

Due to its highly-speculative nature, momentum investing is among the riskiest strategies. It's more suitable for investors that have capital they are okay with potentially losing, as this style of investing most closely resembles day trading and has the greatest downside potential.

Pros and Cons - Momentum Trading

Higher risk means higher reward, and there's greater potential short-term gains using momentum trading.

Momentum trading is done in the short-term, and there's no need to tie up capital for long periods of time.

This style of trading can be seen as simpler as it doesn't rely on bigger picture elements.

Momentum trading is often the most exciting style of trading. With quick price action changes, it is a much more engaging style than strategies that require long-term holding.

Momentum trading requires a high degree of skill to properly gauge entry and exit points.

Momentum trading relies on market volatility; without prices quickly rising or dropping, there may not be suitable trades to be had.

Depending on your investment vehicles, there's increased risk for short-term capital gains.

Invalidation can happen very quickly; without notice, an entry and exit point may not longer exist and the opportunity is lost.

Dollar-cost averaging (DCA) is the practice of making regular investments in the market over time and is not mutually exclusive to the other methods described above. Rather, it is a means of executing whatever strategy you chose. With DCA, you may choose to put $300 in an investment account every month.

This disciplined approach becomes particularly powerful when you use automated features that invest for you. The benefit of the DCA strategy is that it avoids the painful and ill-fated strategy of market timing. Even seasoned investors occasionally feel the temptation to buy when they think prices are low only to discover, to their dismay, they have a longer way to drop.

When investments happen in regular increments, the investor captures prices at all levels, from high to low. These periodic investments effectively lower the average per-share cost of the purchases and reduces the potential taxable basis of future shares sold.

Who Should Use Dollar-Cost Averaging?

Dollar-cost averaging is a wise choice for most investors. It keeps you committed to saving while reducing the level of risk and the effects of volatility . Most investors are not in a position to make a single, large investment. A DCA approach is an effective countermeasure to the cognitive bias inherent to humans. New and experienced investors alike are susceptible to hard-wired flaws in judgment.

Loss aversion bias, for example, causes us to view the gain or loss of an amount of money asymmetrically. Additionally, confirmation bias leads us to focus on and remember information that confirms our long-held beliefs while ignoring contradictory information that may be important. Dollar-cost averaging circumvents these common problems by removing human frailties from the equation.

In order to establish an effective DCA strategy, you must have ongoing cashflow and reoccurring disposable income. Many online brokers have options to set up reoccurring deposits during a specific cadence. This feature can then be adjusted based on changes in your personal cashflow or investment preference.

Pros and Cons - DCA

DCA can be combined with the other strategies mentioned above.

During periods of declining prices, your average cost basis will decrease, increasing potential future gains.

DCA removes the emotional element of investing, requiring reoccurring investments regardless of how markets are performing.

Once set up, DCA can be incredibly passive and require minimal maintenance.

DCA can be difficult to automate especially if you are not familiar with your broker's platform.

During periods of declining prices, your average cost basis will decrease, increasing your future tax liability.

You must have steady, stable cashflow to invest to DCA.

Investors may be tempted to not monitor DCA strategies; however, investments - even ones automated - should be reviewed periodically.

Once You've Identified Your Strategy

If you've narrowed down a strategy, great! There are still a few things you'll need to do before you make the first deposit into your investment account. First, figure out how much money you need start investing. This includes your upfront investment as well as how much you can continue to invest going forward.

You'll also need to decide the best way for you to invest. Do you intend to go to a traditional financial advisor or broker, or is a passive, worry-free approach more appropriate for you? If you choose the latter, consider signing up with a robo-advisor .

Consider your investment vehicles. Cash accounts can be immediately withdrawn but often have the greatest consequences. 401ks can't be touched until you retire and have limited options, but your company may match your investment. Different types of IRAs have different levels of flexibility as well.

It also pays to remain diversified. To reduce the risk of one type of asset bringing down your entire portfolio, consider spreading your investments across stocks, bonds , mutual funds, ETFs, and alternative assets. If you're someone who is socially conscious, you may consider responsible investing . Now is the time to figure out what you want your investment portfolio to be made of and what it will look like.

Establishing Your Investing Principles

When choosing your investment strategy, answer each of these questions:

• Do you want to invest for the short-term or long-term?
• Do you want your investments to be easily accessible or illiquid?
• Do you want to chase risk for higher returns or avoid risk for stability?
• Do you want to manage your own investments or pay an advisor?
• Do you want to actively monitoring your portfolio or be more passive?
• Do you want to invest a little amount over time or a lot all at once?

What Is the Best Investment Strategy?

The best investment strategy is the one that helps you achieve your financial goals. A review of some of the top investors will show that for every investor, the best strategy will be different. For example, if you're looking for the quickest profit with the highest risk, momentum trading is for you. Alternatively, if you're planning for the long-term, value stocks are probably better.

How Do I Set Up an Investment Strategy?

A general investment strategy is formed based on your long-term goals. How much are you trying to save? What is your timeline for saving? What are you trying to achieve? Once you have your financial goals in place, you can set target performance on returns and savings, then find assets that mesh with that plan.

For example, your goal may be to save $1,000,000. To achieve this goal, you must invest $10,000 per year for 29 years and achieve 8% annual returns. Armed with this information, you can analyze various historical investment performance to try and find an asset class that achieves your strategic target.

How Do Beginners Invest in Stocks?

Beginners can get started with stocks by depositing funds in a low-fee or no-fee brokerage firm. These brokerage companies will not charge (or issue small charges) when the investor deposits, trades, or withdraws funds. In addition to getting started with a brokerage firm, you can leverage information on the broker's website to begin researching which asset classes and securities you're interested in.

The decision to choose a strategy is more important than the strategy itself. Indeed, any of these strategies can generate a significant return as long as the investor makes a choice and commits to it. The reason it is important to choose is that the sooner you start, the greater the effects of compounding .

Remember, don’t focus exclusively on annual returns when choosing a strategy. Engage the approach that suits your schedule and risk tolerance . With a plan in place and goal set, you'll be well on your way to a long and successful investing future!

CNBC. " Warren Buffett: I Like Airlines Because They Just 'Got a Bad Century Out of the Way .'"

Dodge & Cox. " Staying the Course in Value Investing ," Page 1.

Arnott, Robert D., et al. "Reports of value’s death may be greatly exaggerated."  Financial Analysts Journal, vol. 77, no. 1, 2021, pp. 44-67.

Maloney, Thomas, and Tobias J. Moskowitz. "Value and Interest Rates: Are Rates to Blame for Value’s Torments?."  The Journal of Portfolio Management, vol. 47, no. 6, 2021, pp. 65-87.

New York University, Stern School of Business. " Growth Investing: Betting on the Future? ," Page 2.

MSCI. " MSCI World Momentum Index (USD) ."

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Making Smart Investments: A Beginner’s Guide

• Matthew Blume

Reduce the risk factor, increase the reward factor, and generate meaningful returns.

If you make smart decisions and invest in the right places, you can reduce the risk factor, increase the reward factor, and generate meaningful returns. Here are a few questions to consider as you get started.

• Why should you invest? At a minimum, investing allows you to keep pace with cost-of-living increases created by inflation. At a maximum, the major benefit of a long-term investment strategy is the possibility of compounding interest, or growth earned on growth.
• How much should you save vs. invest? As a guideline, save 20% of your income to to build an emergency fund equal to roughly three to six months’ worth of ordinary expenses. Invest additional funds that aren’t being put toward specific near-term expenses.
• How do investments work?    In the finance world, the market is a term used to describe the place where you can buy and sell shares of stocks, bonds, and other assets. You need to open an investment account, like a brokerage account, which you fund with cash that you can then use to buy stocks, bonds, and other investable assets.
• How do you make (or lose) money? In the market, you make or lose money depending on the purchase and sale price of whatever you buy. If you buy a stock at $10 and sell it at $15, you make $5. If you buy at $15 and sell at $10, you lose $5.

Where your work meets your life. See more from Ascend here .

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• MB Matthew Blume  is a portfolio manager of private client accounts at  Pekin Hardy Strauss Wealth Management . He also manages the firm’s ESG research and shareholder advocacy efforts. He earned a B.S. in electrical engineering from Valparaiso University and an MBA from Northwestern University’s Kellogg School of Management. Matthew is a CFA charterholder.

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9 Investment Strategies for New Investors

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The best investment strategies increase the money investors make and decrease their exposure to risk.

The strategy will vary depending on your end investment goal and its timeframe, your risk tolerance and how involved you want to be in choosing individual investments.

Many investors combine multiple strategies to find the best personalized strategy to fit their situation.

What's an investment strategy?

An investment strategy is a way of thinking that shapes how you select the investments in your portfolio. The best strategies should help you meet your financial goals and grow your wealth while maintaining a level of risk that lets you sleep at night. The strategy you choose may influence everything from what types of assets you have to how you approach buying and selling those assets.

If you're ready to start investing, a good rule of thumb is to ask yourself some basic questions: What are your goals? How much time until you retire? How comfortable are you with risk? Do you know how much you want to invest in stocks, bonds or an alternative?

This is where investment strategies come into play.

9 popular investment strategies

There are numerous ways to approach investing, and here are some of the more popular investing strategies to consider.

1. Start with a new or existing retirement account

One way to begin investing is through a retirement account. Open or access an individual retirement account, or IRA , through a brokerage account. Then choose investments that are aligned with your goals.

If you already have a retirement account through your employer, it's generally a good idea to contribute to that 401(k) first — and qualify for the company match — before you start funding your IRA. Employer match programs are free money you don't want to leave on the table.  

However, you should know that most 401(k)s offer relatively few investment choices, so the options for strategy within those vehicles are usually limited. Whereas IRAs give you access to a more expansive world of investments than your 401(k) may offer. 

You can also trade through a brokerage account for long-term goals other than retirement.

» Need more direction? Read How to Invest at Any Life Stage

2. Buy-and-hold investing

It’s always nice when things have a clear label, and you can’t get much clearer than “buy and hold.” Buy-and-hold strategists seek investments they believe will perform well over many years. The idea is to not get rattled when the market dips or drops in the short term, but to hold onto your investments and stay the course. Buy-and-hold works only if investors believe in their investment’s long-term potential through those short-term declines.

This strategy requires investors to carefully evaluate their investments — whether they are broad index funds or a rising young stock — for their long-term growth prospects upfront. But once this initial work is done, holding investments saves time you would have spent trading, and often beats the returns of more-active trading strategies.

» Want to know more? Dive into details on buy-and-hold investment strategy

3. Active investing

Active investors prefer trading more frequently and opportunistically to capitalize on market fluctuations. Stock traders may use technical analysis, the study of past market data such as trading volume or price trends, to help anticipate where market prices might go.

Active trading includes different strategies based upon pricing, such as swing or spread trading, and can also include momentum and event-driven strategies. Momentum investing seeks to identify and follow trends currently in favor to profit off of market sentiment. Event-driven investing strategies attempt to capture pricing differences during corporate changes and events, such as during mergers and acquisitions, or a distressed company filing for bankruptcy.

» To time or not to time? Learn more about market timing

4. Dollar-cost averaging

The biggest challenge to timing the markets is getting it right on a consistent basis. For those investors wary of trying their luck on market timing but still wanting a good entry point into the market, the strategy of dollar-cost averaging may appeal.

Investors who dollar-cost average their way into the market spread their stock or fund purchases out over time, buying the same amount at regular intervals. Doing so helps to "smooth" out the purchase price over time as you purchase more shares when the stock price is down and buy less shares when the stock price is up. Over time, you gain a better average entry price and reduce the impact of market volatility on your portfolio.

5. Index investing

While there are active and passive approaches to investing , there are also active and passive investments themselves when deciding between various types of funds. Investors frequently use mutual funds , index funds and exchange-traded funds (ETFs) to populate their investment portfolio because funds provide access to a collection of securities, generally stocks and bonds, through one vehicle. Funds allow investors to benefit from diversification , spreading investment risk across many securities to help balance volatility.

» Learn more: What are ETFs ?

Active funds employ a portfolio or fund manager to handpick certain investments to populate the fund based upon proprietary research, analysis and forecasts. The manager's goal is to outperform the fund's corresponding index or benchmark. Passive funds, such as index funds and most ETFs, simply mimic an underlying index, providing the investor with similar performance to that particular index.

Some mutual funds have high expense ratios or high minimum investments (or both). But investors can often sidestep the highest of such costs by comparison shopping among mutual funds, or by favoring index funds and ETFs, which tend to offer lower expense ratios than actively managed funds. Given the lower cost of passive funds and the arduous task of beating the benchmark facing portfolio managers, index or passive investing often delivers better overall returns over time .

6. Growth investing

Growth investing involves buying shares of emerging companies that appear poised to grow at an above-average pace in the future. Companies like this often offer a unique product or service that competitors can't easily duplicate. While growth stocks are far from a sure thing, their allure is that they might grow in value much faster than established stocks if the underlying business takes off. Growth investors are willing to pay a premium price for these stocks in exchange for their robust future growth potential.

New technologies often fall into this category. For example, if someone believes that home buyers are going to shift increasingly from banks to online mortgage lenders with a streamlined application process, they might invest in the lender they believe will become dominant in that market.

Investors can also look toward burgeoning geographies or companies to find growth. As they industrialize, emerging markets or developing economies usually are more volatile but also grow at a faster pace compared to their more-developed peers. Companies are valued by market capitalization, or market cap, which is calculated by their total outstanding shares available times the market price of the shares. Small-cap stocks, shares of companies usually valued at $2 billion in market cap or less, provide investors with greater potential risk but also greater potential return due to their faster growth trajectory.

7. Value investing

Made famous by investors such as Warren Buffett, value investing is the bargain shopping of investment strategies. By purchasing what they believe to be undervalued stocks with strong long-term prospects, value investors aim to reap the rewards when the companies achieve their true potential in the years ahead. Value investing usually requires a pretty active hand, someone who is willing to watch the market and news for clues on which stocks are undervalued at any given time.

Think about it like this: A value investor might scoop up shares of a historically successful car company when its stock price drops following the release of an awful new model, so long as the investor feels the new model was a fluke and that the company will bounce back over time.

» Grow your investment. Compare and contrast growth and value investing

Value investing is considered a contrarian strategy because investors are going against the grain or investing in stocks or sectors currently out of favor. A subset of investors take value investing a step further by not just investing in cheaper stocks and sectors but purposely seeking out the cheapest ones out there to invest in so-called deep value.

8. Income investing

Investment strategies can help investors achieve a particular aim; for instance, producing a steady income stream. Many investors use income investing to help cover their living expenses particularly when transitioning into retirement.

There are different investments that can produce income, from dividend-paying stocks to bond and CD ladders to real estate .

» Learn more: What is a bond

9. Socially responsible investing

Social issues such as climate change and racial justice impact lives on a day-to-day basis. Socially responsible investing (SRI) aims to create positive change in society while also generating positive returns. In addition to investment performance, SRI investors look into a company’s business practices and revenue sources to ensure they're aligned with their personal values.

Some investors employ SRI by excluding stocks of companies that go against their moral compass; for instance, they might exclude investments in “sin” stocks or tobacco- and alcohol-related companies. Others intentionally direct their investment dollars toward issues they care about, such as into renewable energy companies.

» Want an ethical portfolio? Learn more about socially responsible investing

Principles of investment strategies

Whatever investment strategy you choose, it’s important to consider your investing goals. Where your investment style will fall in the following categories depends on many factors: Everything from your age to your finances and even your comfort level doing it yourself will help determine what your portfolio will look like.

Long-term goals vs. short-term goals

When investing for long-term goals — those five years or more in the future — it may make sense to choose higher-yielding (but more volatile) instruments like stocks and stock funds. But there are smart ways to pursue short-term savings goals, too. If you’re saving for a down payment on a house, you may want to place those savings in a more stable environment, like CDs or a high-yield savings account. Since you have a shorter time frame for your money to grow with a goal like this, there is less time to weather the volatility of the stock market.

» Saving for the short term? Read about the best short-term investment accounts

Long-term savings goals, such as retirement, can handle the fluctuations of the market. Since those investments will be in the market for longer — provided the investor can stay the course when there are major changes in the short term — there is less need to worry about those shorter-term dips. These long-term investments are better served by a mix of stocks and bonds or stock mutual funds.

Low-risk vs. high-risk investing strategy

Investment strategies always come with some amount of risk, and in almost every way risk and reward are linked. Investors who pursue higher rewards are usually taking bigger risks. For example, a bank CD is insured by the Federal Deposit Insurance Corp. and has virtually no risk. It also pays very little in return. A young tech startup’s stock, on the other hand, is likely higher-risk, but there is a chance it could explode in value.

There are many shades of risk in between, but whatever path you choose, make sure you’re prepared to deal with them.

Do-it-yourself vs. hiring professional help

Investors have many choices when it comes to managing their investment portfolio. How involved do you want to be in the investing process? How much do you already know about investing? Beginner investors may prefer to hand their savings off to a robo-advisor — an automated, low-cost investing service — rather than take on the challenge of making all the choices themselves.

More advanced investors or avid DIYers might opt to take a more active role, whether that means trading every day or just keeping tabs on their portfolios. Active investing can be a lot of work and may not give you higher returns than passive investing strategies.

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Quantitative Investment Strategies

2021 key themes in review, key phrase usage in global earnings calls.

QIS looks at over 25,000 global earnings calls across 60+ countries in order to understand what phrases companies are communicating to the public and what topics are being discussed. In 2021, we observed increases in phrases such as “pandemic”, “social media”, “inflation”, “emission”, “retail investors”, “higher cost”, and “climate change.”

Leveraging machine learning techniques lets us monitor what companies are saying and helps us make data-driven investment decisions.

Source: Goldman Sachs Asset Management. Based on data released as of December 31, 2021.

PRIMARY FACTOR PERFORMANCE IN 2021

The QIS Proprietary Value and QIS Quality factors performed positively in 2021, surpassing pre-pandemic levels. Although both traditional Quality and traditional Value exhibited positive performance in 2021, only traditional Quality has surpassed pre-pandemic levels. While performance for traditional Momentum was negative in 2021, performance for the QIS Proprietary version was relatively flat. Additionally, 2021 was a year with high factor dispersion within Value, with cheaper stocks trading at a 42% discount compared to more expensive stocks. This discount is higher than the ten-year average discount of 28%.

Traditional

Quality:  12-month ROE and debt to equity ratio

Momentum:  12 month historical price return

Value:  12-month operating cash flow to price ratio, projected EPS to price ratio, and B/P.

QIS Proprietary

QIS incorporates traditional versions of factors augmented with proprietary signals that leverage machine learning techniques to synthesize vast amounts of nontraditional, unstructured data.

Sources: Goldman Sachs Asset Management. Based on data released as of December 31, 2021. S&P Dow Jones Indices LLC.

Past performance does not guarantee future results, which may vary.

REOPENING THE WORLD

Consumers massively altered their habits in response to the pandemic and associated lockdowns. The QIS team aggregates geolocation data, credit card transaction data, web traffic data, point-of-sale data and other metrics to help us understand which companies may be the beneficiaries of increased consumer attention. We believe that our alternative data signals have been valuable in navigating this evolving market environment.

Source: Goldman Sachs Asset Management. Based on data as of December 31, 2021.

Past correlations are not indicative of future correlations, which may vary.

RISE OF RETAIL TRADING

During the course of the pandemic, individuals poured money into equities and options trading partly due to 1) pandemic factors, such as work from home & reduction in traditional entertainment options and 2) secular causes, such as reduced friction from zero commission trading & expansion of stock ownership. We monitor retail trading activity for alpha opportunities because we believe that retail trading exhibits patterns of short-term persistency due to autocorrelation of flows but medium-to-long-term reversal.

Sources: Bloomberg. Goldman Sachs Asset Management. Goldman Sachs Global Markets Division. CNBC. Subredditstats.com. Statista.com

With the recently increasing inflationary pressures, the QIS team actively monitors different components of inflation in order to create a holistic investment view. Among other considerations, we look at which industries should expect to be impacted by inflation and use natural language processing to identify which industries mention inflation more frequently. Our analysis has found that these and other metrics measure very different features of inflation.

ENVIRONMENTAL, SOCIAL, AND GOVERNANCE (ESG)

Investors poured a record $649 billion into ESG-focused funds worldwide through Nov. 30, up from $542 billion in 2020 and $285 billion in 2019. Additionally, support for environmental and social proposals at US shareholder meetings rose to 32%, a 5% increase from 2020 1 . In order to manage the potential paradigm shift of a transition to a low carbon economy, the QIS team has applied a strategic climate-aware tilt to all its equity alpha portfolios, with the objective of reducing the carbon footprint of our portfolios by at least 25% relative to benchmark.

The track record information and operational commitments on this page also relate to Goldman Sachs’s sustainability practices and track record at an organizational and investment team level, which may not be reflected in the portfolio of the product(s).

Sources: Goldman Sachs Asset Management. Based on data as of December 31, 2021. Goldman Sachs Asset Management, ESG Considerations in the Equity Alpha Investment Process, December 2020. Goldman Sachs, Carbonomics, November 2021

1 Reuters. How 2021 became the year of ESG investing. November 4, 2021 

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Please refer to the full report for important risks additional disclosures.

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• Dec 1, 2017

Will Big Data Be Increasingly Fundamental to Stock Picking?

After a record year of inflows, factor- and quant-based investing is a $1.5 trillion market that is only gaining influence. should fundamental investors be paying attention.

Proponents of bottom-up stock picking say that dispassionate numbers alone cannot predict the success of a stock or asset class; a spreadsheet doesn't capture the talent of a management team or the power of a cyclical trend.

Proponents of quantitative investing—using complex mathematical models to pinpoint opportunities—contend that human emotions, biases and limitations handicap performance. Instead, it’s better to identify the factors associated with superior returns and build models around them.

With data more widespread and complex, the lines between fundamental investing and quantitative investing are blurring.

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But while both styles have their champions, a new Morgan Stanley Research report finds that a combination of the two approaches could be advantageous for investors in either camp.

In fact, according to Martin Leibowitz, Vice Chairman of Morgan Stanley Research and Chair of the firm’s Quantitative Council, there will likely be a broader convergence of fundamental and quantitative investment processes over the next five years.

“Fundamental investors will need to pay greater attention to quant and factor investing, whether as a driver of markets or a complement to their investment process. By extension, for quant investors, combining fundamental and factor approaches—what’s called quantamental—could produce superior returns.”

Quant and Factor: A Rapidly Growing Market

Rise of the machines: automating the future, ready. set. hedge., why advice matters.

Assets in factor and quant-based strategies have increased at a compound annual growth rate of 17% over the past six years, with an estimated $1.5 trillion just in retail funds and hedge funds alone.

While the growth has been impressive, Leibowitz says there is still room to run. “Just a 1% shift in global assets under management each year away from traditional assets—which is not hard to imagine in the current yield-starved environment—translates into a 12% compound annual growth rate for factor assets.”

Investors are paying attention. The Quantitative Council that Leibowitz chairs at Morgan Stanley is comprised of senior quantitative specialists from across the firm with the goal of ensuring that the Morgan Stanley’s quant resources are aligned with the needs of clients and the fundamental strategists and analysts in the Research Department.

Total Smart Beta/Quant/Factor Based AuM ($B)

Quant and Factor Investing Explained

Although investors are becoming more educated on quant and factor investing, it’s worth taking a moment to distinguish between them. Quantitative investing can be defined as a form of active management. Instead of legacy fundamental stock-picking, quant uses complex mathematical models to detect investment opportunities. Like fundamental human analysts, quant can utilize a multitude of strategies under its umbrella, including event-driven, trend-following (momentum), economic data-driven or price inefficiency seeking.

One form of quantitative investing, factor investing, is an investment strategy that seeks to enhance returns, improve portfolio diversification or reduce risk by targeting exposure to specific drivers of risk and return.  These drivers, or factors, are based on valuation, momentum, volatility, quality, and other traits of stocks that investors have traditionally scrutinized.

In factor investing, stocks with favorable combinations of factor exposures, as determined by statistical tests, receive higher weights than do stocks with disfavored combinations of factor exposures. Investment managers can parse and weigh these factors any number of ways to achieve desired investment outcomes, depending on their universe of stocks, investment horizon or other criteria.

So in simplest terms, quant and factor strategies use vast amounts of data to discern the relationships between stock characteristics and overall returns.

The Rise of Quantamental

While factor investing is often associated with rule-based index investing (aka smart beta), active managers are increasingly using factor-based algorithms to reduce risk and maximize returns in the fundamental arena. “We see evidence that combining fundamental and factor approaches—or 'quantamental' investing—can produce superior returns," says Brian Hayes, Global Head of Quantitative Equity Research.

This is particularly true in the era of big data, where public companies can be evaluated not just through company and economic specific data, but also non-traditional data sources like satellite images, internet traffic and logistics data . Fundamental investors must grapple with how to systematically collect, analyze and garner insights from all of this data, while quantitative investors may need fundamental sector expertise to identify reliable patterns.

The upshot: “We see fields of opportunity to boost returns by bridging the fundamental and quantitative divide and combining the investment processes," Hayes says. “This could yield new and greater insights, and enhance alpha generation for those with the technology, tools and process to harness and make sense of it."

Quantamental investing can also improve cross-asset investment decisions. “Factor investing is the next iteration in the evolution of asset allocation, as diversity of return drivers becomes increasingly important in a low-return world," Leibowitz says.

Surprise Results

To test the validity of factor investing—and quantamental investing—the report’s authors systematically constructed factor strategies, both at the individual stock level (micro) and asset class level (macro), globally.

For individual stocks, they created global models for forecasting single-stock performance for 5,400 stocks across developing markets and emerging countries; they studied more than 70 factors classified into four broad categories: valuation, growth and investor sentiment, capital use and profitability, and capital structure and financial leverage.

They then paired those models with Morgan Stanley fundamental analyst ratings. Between 2003 and 2010, a period that included a major equity rally, a quant crisis and one of the worst bear markets in decades, stocks that screened well on the factor-based model and analyst ratings had better historical performance than either approach on a stand-alone basis.

Performance of Various Approaches to Investing (2003 to 2010)

Late Stage or Early Stage?

One question some investors have is that although the growth in factor and quant-based strategies is impressive, how much runway is left?  According to the report, quite a bit.

The report finds that as investor education grows, articulating the advantages of solutions-based investing combined with the shift towards AI and big data techniques to enhance alpha generation versus legacy stock-pickers, the trend will boost factor/quant strategies and accelerate growth into the end of the decade and beyond.

Layer these trends with the structural challenges that traditional active management faces from passive investing, the forecast is that technology-driven investing has a large upside going forward.

Morgan Stanley recently held its 5 th Annual “Quantitative Equity Research and Investment Forum,” which featured presentations by renowned academics, quant practitioners, equity analysts and thought leaders in data visualization. The event also featured an “Innovation Expo” that brought together managers and analysts, data product experts, and leaders in quant and factor research.

For more Morgan Stanley  Research  on quantitative and factor investing, ask your Morgan Stanley representative or  Financial Advisor  for the full report, “Quant Investing – Bridging the Divide" (Oct. 1, 2017). Plus, more  Ideas .

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7 ESG Investment Strategies to Consider

• 15 Sep 2022

As environmental and social issues intensify, the spotlight is on businesses to address growing global concerns . It not only matters how a business performs financially but how it operates and what it stands for.

If you manage investment portfolios, you can invest in firms with high environmental, social, and governance (ESG) ratings to positively impact the world while maximizing returns for your firm and clients.

Here’s a primer on ESG criteria’s role in the investment space and seven strategies to consider for purpose-driven decision-making.

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What are ESG Investment Criteria?

You can use environmental, social, and governance (ESG) factors to evaluate the extent to which a company—and thus, an investment in that company—impacts each of the three areas.

• Environmental refers to a firm’s impact on the environment, including its contributions to climate change, carbon footprint, water use, resource conservation, pollutants, and clean technology use.
• Social refers to a company’s relationships with employees, suppliers, customers, and communities, as well as its contributions toward social good—for instance, human rights, diverse hiring practices, workplace safety, labor practices, data security, and employee and community engagement.
• Governance refers to an organization’s structure, ethics, and management, which include board diversity and independence, executive compensation, transparency and anti-corruption policies, and shareholder rights.

Research conducted by Harvard Business School Professor George Serafeim, explained in the online course Sustainable Investing , states that businesses are most successful in ESG and financial performance measures when efforts are pooled to focus only on factors that directly impact how a company operates—referred to by Serafeim as material ESG factors .

For example, if you own a small technology company with 10 employees, data security would be considered a material ESG issue because your business handles user data. Other factors, like labor practices, would be considered immaterial to your business at its current startup stage and aren’t worth your time, effort, and funds to pursue.

How Investors Use ESG Criteria

“With the growing popularity of incorporating ESG criteria into the decision-making process, sustainable investors are asking for more credible and comparable ESG ratings to help them better understand a company’s ESG performance,” says HBS Professor Shawn Cole, who teaches Sustainable Investing alongside HBS Professor Vikram Gandhi.

According to Cole, only about 30 firms worldwide conduct research to provide comprehensive ESG ratings. Leaders in this space include Morgan Stanley Capital International (MSCI), Sustainalytics, and Thomson Reuters. Although each firm has its own data processing model and classification system, ESG metrics can be extremely useful to investors aiming to make both a positive impact on the world and strong returns on their investments.

As long as you use the same metrics across the board—for example, consistently referencing MSCI’s ratings—you can directly compare companies’ ESG performance and decide which investments to include in your or your clients’ portfolios.

Remember to be wary of impact washing . Similar to greenwashing, impact washing is when fund managers or bond issuers overstate or falsely claim an investment’s positive impact. Doing your own research, in addition to referencing ESG ratings, can help avoid this common pitfall.

Related: 5 Skills Every Sustainable Investor Needs

When building a portfolio with ESG factors in mind, there are seven key strategies to consider. Because sustainable investing is relatively new, there aren’t yet official standards for how to incorporate these factors into decision-making, so choose which best aligns with your motivations, goals, and existing processes.

1. Negative Screening

Negative screening, also called exclusionary screening, is the process of excluding specific companies or sectors from a fund or portfolio. This is executed by determining the criteria for exclusion upfront based on a specific goal.

For instance, if the goal is to decrease climate change’s impact, you may exclude all fossil fuel companies from your portfolio.

2. Positive Screening

Positive screening, also called best-in-class screening, is the process of selecting a subset of top-performing companies from a defined industry and a set of characteristics to invest in.

This can be thought of as the opposite of negative screening. Instead of setting criteria by which to exclude companies, you pre-determine which performance measures you’ll use to select top performers.

For example, you may invest in the 10 apparel companies with the lowest carbon footprint or the five appliance companies with the most diverse boards of directors.

3. Portfolio Tilt

A portfolio tilt strategy is one in which the investor “tilts” the percentage of ESG investments in a portfolio to be more than non-ESG investments while maintaining sector weights that match a target index.

For instance, if you want to match the Russell 3000 index and employ a tilt strategy, you’d select investments from across the index to maintain the same level of risk as the index as a whole. You’d also want to ensure there are more highly rated companies on ESG metrics than low ones.

You may choose this option as a relatively low-risk investment strategy that still prioritizes ESG goals. Positive and negative screening—while highly effective at targeting ESG goals—don’t offer a wide industry variety and naturally exhibit more risk.

4. ESG Integration

ESG integration is a strategic lens that positions companies with high material ESG ratings as investment opportunities that can increase a portfolio’s return. Rather than defining a specific set of requirements—like with positive and negative screening—this strategy embeds ESG considerations into a firm’s existing investment process. It’s another factor that helps provide returns.

You may need to update procedures to consider ESG factors to implement this strategy.

5. Shareholder Action

Shareholder action, also referred to as engagement, is when investors use their power to encourage the companies they invest in to pursue material ESG opportunities.

According to research from the Harvard Law School Forum on Corporate Governance , investors increasingly view corporate attention to ESG issues as closely linked to business resilience, competitive strength, and financial performance. If you invest in a company, advocating for material ESG initiatives can not only do good but increase your returns.

6. Activist Investing

Activist investing is when an investor buys equity in a company to change how it operates and influence it to pursue ESG initiatives. This strategy is closely related to shareholder action; the two terms are sometimes combined into “shareholder activism.” However, there’s one key differentiator: Shareholder action takes place when an investor already owns a company’s shares, and activist investing involves seeking out an investment to influence a company’s ESG strategy .

You may decide to pursue this if you notice a company overlooking a major material ESG opportunity. By buying equity in it now, you can influence its structure and plans to approach ESG and, hopefully, see large returns when the new strategy pays off.

7. Sustainability-Themed Investing

Finally, sustainability-themed investing is a strategy in which investors identify one issue relating to sustainability and invest in indexes of companies that address it.

For instance, if you’re specifically interested in waste management as it relates to the planet’s health, compile an index of companies with exceptional waste management across an array of sectors and risk levels.

This strategy is similar to positive screening, but instead of selecting the top-performing companies, an index is created. In addition, positive screening can apply to any ESG factor, while sustainability-themed investing is specific to issues relating to the environment .

Investing for Positive Impact

The ESG investment strategy you select depends on your firm’s existing structure, processes, and values, as well as your and your clients’ motivations surrounding ESG factors.

No matter which you employ, you can create portfolios that provide returns, both financially and for the greater good.

Are you interested in learning more about how to make a positive impact through investing? Download our free e-book on how to be a purpose-driven, global business professional. Also, explore Sustainable Investing , one of our online business in society courses .

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6 steps to building a long-term investment strategy

Key takeaways

• A good plan starts with a firm understanding of your goals and needs.
• A well-diversified portfolio may help you weather volatile markets and avoid reactionary or emotional decision-making that could potentially hurt your ability to succeed.
• Discussing your plan with your partner, your family, and a trusted financial professional may help you strengthen and further refine your plan.

Investing can be complicated at times, especially if you are managing your portfolio on your own. But the keys to building a solid, long-term investment strategy are relatively straightforward, and can provide you with a framework for decision-making that can help you avoid the common pitfalls and stay focused on achieving your goals.

Here are 6 important steps to building a well-thought-out investment strategy that is flexible, suited to your unique situation, and built to withstand the most difficult market conditions.

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1. Start with a firm understanding of your goals and needs

Before you can invest effectively, you need to have a solid understanding of why you are investing . Take some time to explore and evaluate what your objectives are. Be clear about what motivates you. Clearly articulate both your long-term investment goals and your short-term financial needs. Get specific about timing: For each of your goals, when do you expect to need this money? All investing involves risk—be honest with yourself about how much risk you feel you can tolerate given your current financial situation.

With this information at hand, you can begin to devise an appropriate asset allocation and a tax-sensitive investment strategy that can help you invest in the asset classes and accounts that best fit your goals.

2. Build and maintain a well-diversified portfolio

How your assets are allocated across different asset classes provides a solid foundation upon which your portfolio may be able to grow over time. It can be a major factor in long-term performance: In fact, up to 90% of the variability of a fund's return over time can be explained by how its assets are allocated. 1

Over the long term, holding a diversified portfolio has historically been shown to reduce risk. Developing a portfolio allocation with a thoughtful balance of asset classes may provide you with both the return potential necessary to make progress toward your long-term goal and the stability to help you navigate choppy markets without feeling compelled to abandon your plan.

Regular rebalancing is necessary to ensure that your allocation stays close to its target, as over time the distribution of value among the various asset classes may drift due to changes in the market. "Investors who don't rebalance their portfolios may experience more volatility than they anticipated after a period of rising stocks," says Naveen Malwal, institutional portfolio manager for Strategic Advisers, LLC. "Whereas investors who don't rebalance after a period of stock market volatility may miss out on some or most of an eventual recovery. Rebalancing may help clients feel more confident in their plan over the years." Additionally, it's important to stay vigilant to ensure that you are not overallocated in any single security , as that can present a significant risk to the health of your portfolio.

3. Take advantage of tax-smart investing techniques

The amount you pay in taxes can make a significant difference in your long-term investment returns. A study of pre- and after-tax investment returns from 1926 to 2022 showed that investors who didn't account for taxes when making investment decisions saw their annual returns reduced by 2% on average. 2

Tax-smart investing techniques such as asset location , selecting tax-efficient securities, and tax-loss harvesting may have a substantial impact on your portfolio's long-term growth. But beyond these important considerations, it's important to also keep an eye out for any unexpected tax exposure. For example: In some circumstances, an investor may be required to pay capital gains taxes on a mutual fund investment that they may not have even sold and that perhaps even declined in value. There are several options for investors interested in ways to help mitigate this risk, such as swapping out existing, tax-inefficient mutual funds for tax-managed equivalents or replacing them with a separately managed account (SMA).

"Investors can't control what markets will do, but they can take steps to invest more tax-efficiently," says Malwal. "This may help investors keep more of their gains after taxes."

4. Stick to your plan and stay invested

In tough markets, it's easy to fall prey to your fears and end up making an emotional decision about your money. It's not uncommon for investors to move their money to cash or switch to a more conservative asset allocation. However, these moves may be counterproductive . Historically, many investors who moved out of stocks during down markets didn't fare as well as those who stayed the course, as they often missed out on subsequent rallies.

"Periods of market volatility may be some of the most challenging for investors," says Malwal. "Yet if you look back at 2020, or 2008, or other big market corrections, stocks eventually recovered and went on to make new all-time highs. Investors who stayed invested through the downturn were more likely to fully participate in the recoveries than those who shied away from stocks after the decline." 3

Sticking to your plan and staying invested can be advantageous even when things seem dire. For instance, missing just the 5 best days in the market between 1980 and 2022 could have reduced portfolio returns by as much as 38%. 4 This can be easier said than done, however. Thankfully, there are some steps you can take to help yourself weather the emotional and financial stress that comes with challenging market conditions. You can:

• Learn about common investing biases and how to combat them so you don't overreact in periods of volatility.
• Explore defensive investing , which may help protect your portfolio from steep market declines (at the expense of some potential returns). A defensive portfolio may seek to include more conservative stock investments, high-quality bonds, and alternative investments that are less correlated to the performance of traditional asset classes.
• Consider developing a steady stream of reliable income that isn't dependent on market-based sources (e.g., bonds, dividends, or fixed income annuities), so you aren't stressed about covering your necessary expenses and can better weather near-term volatility.

5. Involve your family when planning and making decisions

If you and your partner have multiple accounts across multiple firms, it can be difficult to develop and maintain a shared vision for your financial future. Working together to create a holistic, all-inclusive plan could be beneficial and may help you identify opportunities to potentially reduce your overall tax burden and help to enhance your long-term investment returns. It may also help you stick to your plan when things get challenging.

If you have young children, it may be wise to get them involved as well—to a degree that is appropriate for their age. That way, they can begin to build the skills necessary to manage their own finances , or act as responsible stewards of the family's money, when the time comes.

6. Consider partnering with a trusted financial professional

If you enjoy managing your own finances and feel confident in your investment knowledge and capabilities, you may be happy to play the role of investment manager for your portfolio. There are, however, other options that can relieve you of some (or most) of these responsibilities , should you prefer it, including full professional management or a more balanced division of responsibilities, such as through a separately managed account (SMA).

While professional management often comes with a cost, industry studies estimate that professional financial advice can add up to 5.1% to portfolio returns over the long term, depending on the time period and how returns are calculated. 5 Good financial professionals will work with you to create a personalized investment plan and identify opportunities to help grow and protect your assets. They may also act as a sounding board during times of uncertainty, helping you maintain focus and composure when markets are volatile.

Keep it simple

A good plan is one you understand inside and out and can stick to, even when times are tough. By following these 6 steps, you may be able to develop an investment strategy that will serve you and your family well into the future.

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"does asset allocation policy explain 40%, 90% or 100% of performance”, roger g. ibbotson and paul d. kaplan, financial analysts journal, january/february 2000. diversification and asset allocation do not ensure a profit or guarantee against loss. 2. taxes can significantly reduce returns data, © 2023 morningstar, inc. all rights reserved. past performance is no guarantee of future results. 3. this example reflects a 97-year period from 1926 to 2022 and is based on the following data: stocks at 10.1%, stocks after taxes at 8.2%, bonds at 5.2%, and bonds after taxes at 2.9%. 4. based on hypothetical growth of $10,000 invested in the s&p 500 index 1/1/1980-6/30/2022. source: fmrco, asset allocation research team, as of june 30, 2022. past performance is no guarantee of future results the hypothetical example assumes an investment that tracks the returns of the s&p 500® index and includes capital gains and dividend reinvestment but does not reflect the impact of taxes, fees, or expenses, which would lower these figures. it is not possible to invest directly in an index. all indexes are unmanaged. "best days” were determined by ranking the one-day total returns for the s&p 500 index within this time period and ranking them from highest to lowest. there is volatility in the market and a sale at any point in time could result in a gain or loss. your own investment experience will differ, including the possibility of losing money. 5. depending on the time period and how returns are calculated. value of advice sources: envestnet’s “capital sigma: the advisor advantage” estimates advisor value add at an average of 3% per year, 2023; russell investments 2023 value of a financial advisor estimates value add at approximately 5.12%; and vanguard, “putting a value on your value: quantifying vanguard advisor’s alpha®,” 2022, estimates lifetime value add at an average of 3%. the methodologies for these studies vary greatly. in the envestnet and russell studies, the paper sought to identify the absolute value of a set of services, while the vanguard study compared the expected impact of advisor practices to a hypothetical base-case scenario. past performance is no guarantee of future results. investing involves risk, including risk of loss. annuity guarantees are subject to the claims-paying ability of the issuing insurance company. alternative investments are investment products other than the traditional investments of stocks, bonds, mutual funds, or etfs. examples of alternative investments are limited partnerships, limited liability companies, hedge funds, private equity, private debt, commodities, real estate, and promissory notes. some of the risks associated with alternative investments are: - alternative investments may be relatively illiquid. - it may be difficult to determine the current market value of the asset. - there may be limited historical risk and return data. - a high degree of investment analysis may be required before buying. - costs of purchase and sale may be relatively high. this information is intended to be educational and is not tailored to the investment needs of any specific investor. diversification and asset allocation do not ensure a profit or guarantee against loss. stock markets are volatile and can fluctuate significantly in response to company, industry, political, regulatory, market, or economic developments. investing in stock involves risks, including the loss of principal. in general, the bond market is volatile, and fixed income securities carry interest rate risk. 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An impact investment strategy

• Original Research
• Open access
• Published: 05 April 2023
• Volume 61 , pages 177–211, ( 2023 )

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• Kumari Juddoo 1 ,
• Issam Malki   ORCID: orcid.org/0000-0001-6902-9598 1 ,
• Sudha Mathew 1 &
• Sheeja Sivaprasad 1  

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Impact investing is based on using the ESG framework as a tool to evaluate firms that engage in generating positive impact. Most impact investors and fund managers now integrate the ESG framework in their investment and stock-picking process. However, due to lack of standardisation of ESG reporting, it remains a challenge for investors and the public to identify the truly sustainable companies. We propose an additional measure of tax avoidance to identify firms that are socially responsible. When firms indulge in excessive tax avoidance behaviour, it may be viewed as unethical or socially irresponsible. We integrate the empirical association between corporate social responsibility and tax avoidance into an investment strategy based on impact. We adopt an investment strategy based on firm‐level ESG ratings and tax avoidance practices. In a pure impact investment strategy based on ESG and tax avoidance, we find that investing in high‐ESG rated firms and low tax avoidance firms yields a buy and hold abnormal return of 3.4% per annum and 11.4% in a 3 years investment horizon. Next, if impact investors were to combine traditional investment strategies based on risk with impact measures, we find that portfolios of high‐ESG and high price‐to‐book‐ratio firms earn a buy and hold abnormal return of 21.2%, while a portfolio of low tax avoidance and high price-to-book portfolios earns 29.8% in the long run. Collectively, our results suggest that, whilst impact investing does provide investors a return, it does not necessarily outperform traditional investment strategies. Our results are robust to other risk factors and the sector of the firm.

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1 Introduction

In his book, Impact: Reshaping capitalism to drive real change , Sir Richard Cohen states that “impact” is currently regarded as a revolution and should be the heart of any economic system (Cohen 2020 ). Impact investing is defined as investments made with the aim to generate positive, measurable social and environmental impact alongside a financial return. According to Global Impact Investing Network (GIIN), the aggregate assets under management increased from $502 billion in 2019 to $715 billion in 2020 (GIIN 2020a ). In 2022, the worldwide impact investment market is estimated to be $1.163 (GIIN 2022 ). Undoubtedly, the pandemic has also fuelled demand for impact investments (GIIN 2020b ). In the UK, impact investing has grown, increasing from £830 million in 2011 to £58 billion in 2022 (Impact Investing Institute 2022 ). The former UK Chancellor, Mr. Rishi Sunak, in his 2020 Spending Review, announced the creation of a new National Infrastructure Bank, where one of its core objectives is to help tackle climate change, particularly meeting the net zero emissions target by 2050. The Financial Stability Board created the Task Force on Climate-related Financial Disclosures (TCFD) to improve and increase reporting of climate-related financial information (Financial Stability Board) (TCFD 2021 ). The government has also announced that full mandatory climate-related financial disclosure requirements will come into force across the UK by 2025. The UK Financial Reporting Council (FRC) recently developed the Sustainability Accounting Standards Board disclosures (SASB) framework as a guide for environmental, social and governance (ESG henceforth) reporting (FRC 2020 ).

Rating agencies use firm disclosures, media reports, news items, surveys and interviews to collect data to formulate an environmental, social and governance (ESG) score that represents ESG actions and activities of a firm. Impact investment strategies traditionally use ESG score, as well as financial performance, to choose firms to form a portfolio (Tosun 2017 ; Brooks and Oikonomou 2018 ). Lopez and Contreras and Bendix ( 2020 ) state that there are certain variables that can be predictive of ESG initiatives. They also argue that there is deviation among the agencies, such as Thomson Reuters, RobecoSAM, and Sustainalytics, in their measure of ESG scores. However, despite efforts and calls by regulatory bodies, such as the Financial Reporting Council, for consistency and reliability in ESG reporting and disclosure, it remains a challenge for investors and the public to identify the truly sustainable companies and financial products from those that engaged in “greenwashing”.

Previous studies investigate the relation between corporate social responsibility (CSR) and firm performance and find a positive relationship (Deng et al. 2013 ; Lins et al. 2017 ; Adegbite et al. 2019 ). A meta-analysis by Huang et al. ( 2020 ) and Gilan et al. ( 2021 ) finds that, due to public and regulatory concerns, managers are increasing CSR efforts with the aim of improving the firm's value. They find mixed results of the relation between CSR and corporate financial performance in previous literature. This could be due to the non-standardisation of disclosure, measurement and reporting of CSR activities by firms (Kotsantonis and Serafeim 2019 ; Berg et al. 2020 ).

Following the strand of literature that documents a close association between CSR and tax avoidance, this study proposes another measure to assess the social responsibility of a firm, which is tax avoidance (TA henceforth). TA represents the corporate social responsibility of the firm (Mansi et al. 2020 ); it is an important measure not adequately captured by the ESG score (Huseynov and Klamm 2012 ; Lopez et al. 2020 ). Even though tax avoidance is essentially a legal practice, we argue that TA could capture the ethical and social responsibility dimensions of a firm in terms of paying corporation taxes that can lead to huge societal benefits. Firms are held responsible to both internal and external stakeholders, which includes society, and are expected to follow rules, laws and regulations; especially in the case of taxation (Huseynov and Klamm 2012 ). Our study will explore how an impact investor can form portfolios based on impact criterion such as firms with high ESG score and low TA.

The primary aim of this paper is to examine the investment performance of a pure impact investment strategy. Using a sample of non-financial firms on FTSE All Share, we use ESG ratings and tax avoidance practices of firms as the basis of an impact investment strategy. To our knowledge, this is one of the first studies to empirically associate tax avoidance and ESG ratings in impact investing. The main objectives of this study are as follows:

To empirically test the relation between ESG ratings, tax avoidance practices and investment performance;

To identify the defining features of impact investing based on a pure impact strategy of ESG and TA;

To evaluate relative performance of impact investing strategies combined with traditional investment strategies.

Our findings indicate that, in both the short and long run investment horizons, an impact strategy based purely on impact measures of high ESG and low TA earns 11.4% in a 3 years investment horizon. When we combine impact factors with traditional investment criterion based on firm fundamentals, we find that portfolios of high‐ESG and high price‐to‐book‐ratio firms earn 21.2%, returns, while a portfolio of low tax avoidance and high price-to-book portfolios earns 29.8% in the long run. The regression results confirm that an impact investor earns a risk-adjusted return, and this is more pronounced in the longer investment horizon.

The contributions of our study are four-fold: First, to our knowledge, this is the first study that introduces tax avoidance as an additional impact measure; second, it assesses the performance of an investment strategy based on impact using risk-adjusted returns across varying investment horizons; and third, this study also provides an investment strategy that combines impact variables with firm and market fundamentals. Finally, the findings from this paper can help institutional investors, and the investment community to use TA as a practical measure for better evaluation of their impact investment policies.

Taxation is a major fiscal revenue for most governments that is then channelled towards societal benefits. However, billions of tax revenue are being lost due to tax avoidance (Independent 2019 ). Consequently, for firms, taxes represent a major component of their expenses and, through tax planning, they attempt to reduce their tax expense. Davis et al. ( 2016 ) show that corporate social responsibility is negatively related to tax avoidance. Following this study, we argue that a high degree of tax avoidance (defined as below the median of the cash effective tax rate) would be less attractive to an impact investor as these firms would not be engaging in responsible activities.

Impact investing has generated a lot of interest amongst academics as well. For example, Block et al. ( 2021 ) examine the investment criteria for impact investors and find that financial sustainability ranks higher than the social implications of their impact investments for equity investors. Berry and Junkus ( 2013 ) find that both socially responsible investors as well as those not inclined to invest in impact investments consider environmental issues to be the most important criterion whilst making impact investment decisions. Dawkins ( 2018 ) documents that socially responsible investments integrate environmental, social and governance (ESG) criteria into investment decisions. Following this strand of literature, we use ESG ratings as one of the investment-criteria for selecting socially responsible firms. High scores of ESG signal to investors that the environmental, social and governance pillars rank high on the list of priorities for the business apart from earning profits. However, as highlighted earlier, due to the constraints in ESG disclosure and reporting, this study proposes an additional impact investment criterion, i.e. tax avoidance. Firms that indulge in tax avoidance incur a huge cost to the society and are viewed as irresponsible and unethical (Weisbach 2002 ). Moreover, Hoi et al. ( 2013 ) document that firms that engage in responsible corporate social activities have a lower likelihood of engaging in tax avoidance activities. It has also been well-documented in the literature that firms involved in high social responsibility activities will tend to not engage in excessive tax avoidance (Hasan et al. 2017 ). In other words, there is a negative relationship between ESG and TA. Following this line of argument, this study posits that impact investors can use tax avoidance as an investment measure for selecting impact investing stocks.

The remainder of the paper is organised as follows: Sect.  2 provides the literature review, while, in Sect.  3 we describe the rationale behind our sample-selection procedure, as well as the variables and methods we apply. We present and discuss our results in Sect.  4 and Sect.  5 concludes.

2 Prior work

Previous studies use firm variables such as price-to-book (Chan et al. 1991 ), size (Banz 1981 ), leverage (Fama and French 1992 ) and market risk (Sharpe 1964 ) as the basis of traditional investment strategies to explain and predict stock returns. These studies are primarily based on the risk-return trade off models. Recent studies explore the returns of impact investing and find that responsible investors are willing to accept lower financial yields (Barber et al. 2021 ; Geczy et al. 2021 ) in return for environmental and social benefits. Other studies examine: impact of institutional investors on CSR activities (Kim et al. 2019 ); the effect of perceived barriers to social impact investing in the third sector (Phillips and Johnson 2021 ); and investor criteria in social enterprises (Block et al. 2021 ). In this study, we develop an impact investment strategy based on two measures, i.e. ESG ratings of firms and the level of tax avoidance of firms.

2.1 CSR and impact investing

Socially responsible firms are expected to act in the interest of all their stakeholders and this would be in the long-term interest of the firm (Campbell 2007 ). Previous studies that investigate the relationship between corporate social responsibility (CSR henceforth) and firm performance find a positive relationship via the channels of: building up social capital and trust (Lins et al. 2017 ); gaining stakeholder support (Deng et al. 2013 ); motivating employees leading to employee satisfaction (Edmans 2012 ); lowering cost of capital (Dhaliwal et al. 2011 ; Albuquerque et al. 2019 ); lowering idiosyncratic risk and the probability of financial distress (Lee and Faff 2009 ; Nandy and Lodh 2012 ); improving efficiency by investment in CSR (Lin et al. 2021 ) or generating a reputation effect that may have an impact on valuation (Hong and Liskovich 2016 ). On the other hand, there are studies that find a negative relationship between corporate social responsibility and firm performance (Moore 2001 ; Kruger 2015 ; Duque-Grisales et al. 2021 ). The literature indicates that the costs of implementing CSR outweigh benefits in the short term, while benefits are likely to outweigh costs in the long term (Muller 2020 ).

CSR has been about self-regulation of firms and currently there is no standardisation of reporting of CSR activities by firms. Rating agencies use firm disclosures, media reports, news items, surveys and interviews to collect data to formulate a score that is used to measure a firm’s CSR performance. This is known as the ESG score and which represents the Environmental, Social and Governance actions and activities of a firm. Previous studies (Eccles et al. 2014 ; Tosun 2017 ; Adegbite et al. 2019 ) use the ESG measure to analyse the impact of CSR activities on firm performance. Similarly, this study uses ESG scores as a variable for impact investors to choose responsible firms for their portfolio. Using median ESG scores for the portfolio formation period, we classify our sample of firms into two groups, that is, low ESG and high ESG. We contend that firms belonging to the low ESG (ESG below the median) category are firms with low social responsibility. We consider firms belonging to the high ESG (ESG above the median) category as highly socially responsible firms. Hence, we posit that an impact investor would select firms that belong to the high ESG category as these firms are regarded as being socially responsible.

Despite the widespread use of ESG scores as a measure, studies have criticised the usage of the ESG measures due to the lack of global and standardised ESG reporting (Liang et al. 2020 ). Different methodologies used by the rating agencies and the reliability of the unstandardised data, meaning the score can be quite divergent (Huseynov and Klamm 2012 ; Liang et al. 2020 ; Lopez et al. 2020 ). Due to the inconsistency of the ESG scores, it is challenging for investors to use this score as a reliable measure to select responsible firms for impact investment purposes.

Following the strand of literature that documents a close association between CSR and tax avoidance (Hoi et al. 2013 ; Hassan et al. 2017 ), this study proposes an additional measure that impact investors could use as an investment criterion in impact investing. The following section presents the discussion on the role of tax avoidance in impact investing.

2.2 Tax avoidance and impact investing

Tax avoidance refers to minimisation of the tax liability within the framework of the law (Miller and Oats 2014). However, when firms indulge in excessive tax avoidance behaviour which is not in the “spirit” of the law it may be viewed as unethical or socially irresponsible (Hasseldine and Morris 2013 ). In the UK for the year 2018–2019, HMRC reported £1.7 billion as the avoidance tax gap, Footnote 1 of which more than 50% represents corporation tax gap (HMRC 2021 ).

Previous literature documents mixed evidence on the relation between tax avoidance and firm value. Some studies find a positive relation between tax avoidance and firm value (Desai and Dharmapala 2009 ; Wilson 2009 ; Simone and Stomberg 2012 ) and others find a negative relation (Hanlon and Slemrod 2009 ; Balakrishnan et al. 2011 ; Neville and Treanor 2012 ; Ault et al. 2014 ; Chen et al. 2014 ; Blaufus et al. 2019 ). Previous studies calculate tax avoidance using measures such as annual or long run cash effective tax rate (Dyreng et al. 2008 ; Hanlon and Heitzman 2010 ); GAPP effective tax rate (Hanlon et al. 2007 ; Frank et al. 2009 ; Lanis and Richardson 2013 ; Rudyanto and Pirzada 2020 ) or book-tax differences (Desai and Dharmapala 2009 ; Wilson 2009 ).

This study uses the annual cash effective tax rate (CETR) as a measure of tax avoidance. Footnote 2 Using median CETR, we classify our sample of firms into two groups, that is, low tax avoidance and high tax avoidance. We contend that firms belonging to the low tax avoidance (CETR above the median) category minimise their tax liability by using normal tax planning. We consider firms belonging to the high tax avoidance (CETR below the median) category to be engaging in excessive Footnote 3 tax avoidance practices and, hence, are regarded as being socially irresponsible. Hence, we posit than an impact investor would select firms that belong to the low tax avoidance category as these firms are regarded as socially responsible.

Carroll ( 1991 ) posits that CSR consists of economic, legal, ethical and philanthropic responsibilities and argues that taxes fall within this remit. From a firm’s perspective, reducing their tax expense would improve profitability and, in turn, increase shareholder wealth. However, paying taxes is a regulatory requirement and one must also bear in mind that taxes constitute a major source of government income that is then used to support social initiatives for the wellbeing of the society and environment. Huseynov and Klamm ( 2012 ) find that a firm’s tax strategy may be viewed either positively or negatively by stakeholders. We posit a firm that does not engage in excessive Footnote 4 tax avoidance would be regarded positively by an impact investor.

Prior research documents a negative association between CSR and tax avoidance. For example, Sikka ( 2010 ) argues that paying taxes is a social responsibility of firms and these revenues can be used for the general welfare and for the benefit of society. Lanis and Richardson ( 2013 ) find a strong positive and significant association between tax aggressiveness and CSR disclosure and Davis et al. ( 2016 ) find evidence that more socially responsible firms are likely to display less tax avoidance. Hassan et al. ( 2017 ) find strong negative associations between social capital and tax avoidance and conclude that these findings are important when it comes to socially irresponsible activities. Hoi et al. ( 2013 ) find that firms with excessive irresponsible activities tend to have more aggressive tax avoidance and, thereby, corporate culture can affect tax avoidance. Other studies find evidence that CSR and tax avoidance are contradictory activities (Park 2017 ; Goerke 2019 ; Inger and Vansant 2019 ; López-González et al. 2019 ) and hence have an inverse relation. Based on this discussion, we use tax avoidance as an additional and possibly robust measure whilst choosing impact investments.

3 Materials and methods

We obtain this data set from Datastream-Thomson Reuters. We begin with all 591 companies listed on the London Stock Exchange (LSE) from 1999 to 2021. For each firm year observation to enter the sample, we require that a fiscal year-end ESG, cash tax paid and stock price series be available for at least 12 months. We exclude financial companies, companies that changed the fiscal period’s year-end date during the research period, companies that do not have matching year-end ESG scores, negative cash effective tax rate, negative price-to-book values and leverage are not within the range 0 and 99.99. This resulted in 2478 observations left for the analysis. First, firms are ranked based on their ESG scores and are then divided into two groups based on their ESG ratings.

Furthermore, we apply three different approaches to analysing impact investment. This includes both univariate and bivariate portfolio formation (Sect.  3.2 ), panel data portfolio selection regressions (Sect.  3.3.1 ) and portfolio performance evaluation regressions (Sect.  3.3.2 ).

3.1 Measures

3.1.1 returns.

Portfolio return is measured using buy-and-hold abnormal returns (BHAR henceforth). BHARs employ geometric returns in calculating the overall return over the period of interest. In addition, BHARs allow for compounding and capture investors’ experience (Lyon et al. 1999 ). We calculate 1 and 3 months BHARs to capture the short run performance and 1 and 3 years BHARs to capture medium to long run performance. We calculate BHARs using the following formula:

where \(R_{i,t}\) is the return on stock i in month t , \(R_{m,t}\) is the return on market portfolio. We used the FTSE All Share as proxy for the market portfolio.

3.1.2 Variables Footnote 5

For this paper, we rank the firms according to two impact measures; corporate social responsibility measured by ESG score and tax avoidance (TA) Footnote 6 is measured by Cash Effective Tax Rate (CETR henceforth). ESG score used is defined as the ESG combined score; it offers a comprehensive evaluation of a company’s ESG performance. The score captures ESG pillar scores and ESG controversies, the latter capturing the effect of negative media stories. Thus, when companies are involved in ESG controversies, the ESG combined score is computed as the weighted average of the two components. CETR is measured as the ratio of cash tax paid Footnote 7 and the pre-tax income.

In addition to using pure impact measures, we also rank firms using known market-based risk measures including the size of the firm (SIZE), price-to-book ratio (PTBV), leverage and risk (BETA).

3.2 Portfolio formation

The portfolio rebalancing strategy that we adopt is a buy and hold strategy (BHAR) where the portfolio is rebalanced at the end of each holding period. We argue that BHAR is the best method to evaluate investment performance (Jegadeesh and Titman 2001). We construct portfolios using two approaches: univariate and bivariate. In both cases, we define two categories to classify portfolio performance: high and low. The categories (C) are defined as:

where \(Med\left( {x_{t} } \right)\) is the median Footnote 8 of a given variable \(x_{t}\) (e.g. ESG combined scores). Equation ( 3 ) implies that all values below the median value of a given variable fall into low category while values above the median value fall into high category. Thus, firms assigned to each category reflect their performance under the assigned categories. One exception in this interpretation is the tax avoidance variable. Since low (high) values of CETR imply high (low) tax avoidance, low (high) category is defined when CETR is above (below) its median value. The high-low categories as defined above are also consistent with the univariate approach to portfolio formation.

The bivariate approach to portfolio formation requires further interacting categories. Since our aim is to focus on the choice of responsible investments, all the pairwise portfolios involve at least one of the two impact variables, ESG and TA. This implies that we have three types of portfolios: (i) ESG-TA portfolios, (ii) ESG and market risk factors and (iii) TA and market risk factors. Each set of the pairwise portfolios yields four outcomes: \(C_{L} \cap C_{L} { }\) , \(C_{L} \cap C_{H}\) , \(C_{H} \cap C_{L}\) , and \(C_{H} \cap C_{H}\) .

3.3 Panel regression models

Linear models assume a constant and linear effect across all possible values of dependent and independent variables. Second, the standard econometric approach employed in the literature consists of using panel data models allowing for two effects, including fixed or random effects (FE and RE, respectively). These models, however, are restricted with two levels of errors at most and allow one type of error effect at a time (either FE or RE). This limitation may not allow for the true structure of the data to be captured when data are of a nested structure or clustered (Cameron and Trivedi 2005). The data we employ in this paper are of firms within sectors, which fit the multilevel structure that FE and RE models cannot capture. Thus, if we wish to capture the true structure of the data at hand, we need to allow for three levels: the linear function of the overall random term, level-two error representing firms and level-three variable reflecting sectors. We, therefore, specify a mixed linear model; namely multiple random effects model.

We also examine the differences in BHARs between the portfolios formulated using the methods in Sect.  3.3 . This is done by comparing using two approaches: (i) the analysis of dependency using linear regressions and (ii) the analysis of causality using potential outcome framework.

The general specification of the mixed linear model, MLM, used in this paper is formally expressed as:

where \(y_{it}\) is firms’ performance, which includes \(y_{it} = \left\{ {BHAR1M_{it} ,\,\,BHAR3M_{it} ,\,\,BHAR1Y_{it} ,\,\,BHAR3Y_{it} } \right\}\) . The term \(x_{it}^{\prime } \beta\) is the fixed effect part of the model, which refers to the conditional mean of the model. The raw vector, \(x_{it}^{\prime }\) , includes the set of explanatory variables and the intercept. The error term is defined by the terms: \(z_{it}^{^{\prime}} u_{i} + \varepsilon_{it}\) , where \(z_{it}\) is the set of observable variables, and \(u_{i}\) and \(\varepsilon_{it}\) are iid normally distributed random variables with zero means. Formally, we have \(u_{i} \sim N\left( {0,{\Sigma }_{u} } \right)\) and \(\varepsilon_{it} \sim N\left( {0,\sigma_{\varepsilon }^{2} } \right)\) where the random effects parameters are the covariances and variances in \({\Sigma }_{u}.\)

The random effects part, \(z_{it}^{\prime } u_{i}\) , includes the overall random error term, firms’ and sectors’ random effects. The fixed effect part, however, takes different specifications depending on the type of portfolio selection we wish to test. The general specification of the fixed effect part can be specified as follows:

where \(\mu\) is the grand average, \(\tau_{t} = \sum\nolimits_{j = 2}^{T} {d_{j} year_{jt} }\) and \(d_{j}\) are the year effects with the base year captured by the grand average referring to year 2002. We estimate this general specification over the full sample to examine the overall effect of ESG, TA and market fundamentals to maintain the assumptions that the relationship is linear and stable over time. We relax this assumption by allowing various linear restrictions to allow for different effects. We also use different measures specifications and variations to capture different effects. This includes the following:

3.3.1 Portfolio selection regressions

We allow here for the non-linearity of the relationship by accounting for each of the portfolio selections. This consists of univariate and bivariate approaches. In other words, we estimate the specification in (4) for j subsamples where \(j = 0,1,2, \ldots ,9\) denotes: full sample, low ESG, high ESG, low TA, high TA, low ESG–low TA, high ESG–low TA, low ESG–high TA and high ESG–high TA, respectively. The model in (4) is, therefore, modified to reflect this as follows:

3.3.2 Linear restrictions

These are imposed to test various specifications associated with portfolio selection criteria. The following are the linear restrictions we impose on specification ( 6 ):

Low and high ESG restrictions: we impose two linear restrictions on CETR and the interaction ( \(ESG_{it} \times CETR_{it}\) ), or \(\beta_{2} = 0{ }\) and \(\beta_{3} = 0\) , respectively. These two linear restrictions allow capturing the effect of ESG under the assumption that only ESG is used as criterion to determine the outcome of responsible investing. Under this restriction, we hypothesise that, for high ESG, the estimated effect is positive (i.e. \(\hat{\beta }_{1} > 0\) under high ESG or \(\hat{\beta }_{1}^{3} > 0\) ).

Low and high TA restrictions: Here, we allow for the effect of CETR to be present under the assumption that only TA is used as criterion by investors. This implies we impose zero linear restrictions on the coefficients of ESG and ( \(ESG_{it} \times CETR_{it} )\) , or \(\beta_{1} = 0{ }\) and \(\beta_{3} = 0,\) respectively. Under this restriction, we hypothesise that, for higher values CETR (Low TA), the effect of CETR is positive (i.e. \(\hat{\beta }_{2} > 0\) for higher CETR).

Bivariate (combined) ESG and TA criteria: we impose here different combinations of linear restrictions including: (a) excluding CETR and the interaction ( \(ESG_{it} \times CETR_{it}\) ) or \(\beta_{2} = 0{ }\) and \(\beta_{3} = 0\) , (b) excluding ESG and the interaction ( \(ESG_{it} \times CETR_{it}\) ), or \(\beta_{1} = 0{ }\) and \(\beta_{3} = 0\) , and (c) and excluding the interaction ( \(ESG_{it} \times CETR_{it}\) ), or \(\beta_{3} = 0\) . Under these restrictions, we find positive overall effects under high ESG – low TA combination. Footnote 9

3.3.3 Portfolio performance evaluation regressions

The above models, as with much of the literature, do not allow for the causal effects of the ethical and responsible investment on performance. Therefore, we propose to capture the direct effect of each portfolio selection on the outcome of the investor, to estimate the average BHARs due to choosing a particular portfolio conditional on market fundamentals.

The modelling strategy involves defining portfolio selection as a treatment variable. Given there are four potential portfolio selections, the treatment level is multivalued treatment (i.e. it takes more than two values). Thus, we aim to estimate the outcomes of each of the treatments using a general framework known as the potential outcome model.

Suppose that the treatment variable takes \(G + 1\) different values, labelled as \(\left\{ {0,1,2, \ldots ,G} \right\}\) where “0” refers to the control group and \(1,2, \ldots ,G\) refer to different levels. Each respondent has been assigned one of G + 1 possible treatment levels, g = 0, 1, 2,…,G. Furthermore, we observe for each individual the vector

where \(y_{it}\) and \(x{^{\prime}}_{it}\) (which is a \(k \times 1\) vector) are the same as in Sect. 3.4 above. The observed outcome variable, \(w_{i} ,\) is the treatment level. The indicator variable, \(d_{it} \left( {\text{g}} \right) = 1\left( {w_{it} = {\text{g}}} \right)\) , which takes the value 1 if the respondent i in time t is in the group g and the value of zero otherwise. Note that the function \(1\left( {{ }.{ }} \right)\) is the indicator function, the vectors \({\varvec{z}}_{it}\) are independent and identically distributed draws of the vector \({\varvec{z}} = \left( {{\text{y}},{\text{w}},{\mathbf{x}}{^{\prime}}} \right)\) and \(d\left( {\text{g}} \right) = 1\left( {w = {\text{g}}} \right)\) .

The classical potential outcome framework distinguishes between the observed outcome \(y_{it}\) and the G + 1 potential outcome \(y_{it} \left( G \right)\) for each treatment level g = 0, 1, 2,…,G. The observed response \(y_{it}\) can be expressed as follows:

We define \(\mu_{g} = E\left( {y_{it,g} } \right)\) as the population means of counterfactuals. Under sufficient ignorability for identifying the means, it requires the conditional mean independence assumption

It follows from this that:

which shows that \(E(y_{g} |x)\) is identified because \(E\left( {y_{g} {|}x} \right) = E(y|w = {\text{g}},x)\) . The latter can be estimated for each \({\text{g}}\) by restricting attention to units with \(w_{it} = {\text{g}}\) .

The potential outcome for each treatment is estimated using conditional mean in ( 10 ). This is achieved by estimating the conditional probability of choosing a portfolio given the set of variables in \(x_{it}\) , known as Generalised Propensity Score. Once this is done, we can estimate the average outcome or return for each portfolio selection using various estimators, including regression adjustment, inverse probability weighting and augmented inverse probability weighting.

3.3.4 Fama–French factor models

We also assess the performance of the portfolios using the three variations of the Fama–French factor models. Footnote 10 We modify Eqs. ( 5 ) and ( 6 ) to fit the structure of these models. Let \(y_{it} = \left( {r_{it} - r_{ft} } \right)\) , where \(r_{it}\) is the return on stock i in month t, \(r_{ft}\) is the return on the 1 month-yield in month t. The fixed effect part of model ( 6 ) takes the following forms:

where \(r_{mt}\) is the return on the market portfolio in month t, \(SMB_{t}\) is the difference in return between small cap portfolio and a large cap portfolio at month t, \(HLM_{t}\) is the difference in return at time t between a portfolio containing value stocks and one consisting of growth stocks, \(WLM_{t}\) is the difference in return at month t between the returns of the high and low returns stock portfolios, \(RMW_{t}\) is the difference between the returns of stocks with robust and weak profitability, and \(CMA_{t}\) is the difference in return at month t of conservative and aggressive investment stocks. The term \({ }\tau_{t}\) is the time of the individual effect as defined above. We follow the same approach as with models ( 5 ) and ( 6 ) for j subsamples.

4 Findings and discussion

Panel A of Table 1 reports summary statistics for the BHARs measures, impact variables and known market risk factors. We report key statistics for the overall sample, across ESG categories and across TA categories (low and high). The overall sample mean of BHARs is between 0.1 and 14%, showing that the longer the time horizon, the higher the portfolio returns. The standard deviation and range indicate skewed and dispersed distributions of the BHARs. The mean ESG is 49.2, which is slightly below the average. The sample mean of TA is 0.25, closer to zero, which is the lower bound of the range, indicating centre of the data around high levels of tax avoidance.

Panel B of Table 1 reports the correlation matrix. Part A reports the correlation matrix between BHARs and other variables. In general, returns as measured by BHARs have negative and weak statistical association with ESG, risk and leverage, while their statistical association is found to be positive with TA, SIZE and PTBV. The correlations are mostly significant with just a few exceptions including between BHAR3Y and TA and BHAR1M and BHAR3M and risk. Part B also reports the pairwise correlation between explanatory variables. The correlation matrix does not report any evidence of the presence of linear dependence between the explanatory variables.

4.1 Univariate analysis

Under this analysis, we identify two categories, high and low as defined in Eq. ( 3 ). We then make portfolio assignments based on firms’ ESG and TA. Next, we compute the BHARs for each portfolio. We then test (i) the significance of the BHARs and (ii) whether BHARs in different categories are statistically different.

Table 2 reports the univariate analysis; this contains the average BHARs, average ESG scores and average TA across different groups by ESG scores and TA. Groups with low ESG and TA are referred to as \(ESG_{L}\) and \(TA_{L} ,\) respectively. Groups with high ESG and TA are denoted \(ESG_{H}\) and \(TA_{H} ,\) respectively. We note that stock returns are all statistically significant across the ESG and TA groups. According to Table 2 , the computed BHARs are all positive and significant with one exception for the portfolio of high ESG and high TA in the long term. Our findings suggest that performance is consistently higher in the low ESG and high TA groups. The BHAR1M to BHAR3Y are found to be ranging from 3 to 23.8%. Furthermore, the test Footnote 11 of the differences between BHARs across the four groups ( \(ESG_{L}\) , \(ESG_{H} ,\) \(TA_{L}\) and \(TA_{H}\) ) shows that BHARs are statistically significant except for BHARs estimated for high ESG and high TA. The test shows that calculated BHARs under \(ESG_{L}\) are higher than those in \(ESG_{H}\) by around 0.1–13.7%, and by around 0.1–3% lower than those under \(TA_{L}\) ; and by around 0.1–4% higher than those computed for \(TA_{H}\) . In contrast, the computed BHARs for \(ESG_{H}\) are found to be less than those computed for \(TA_{L}\) by about 0.1–10%. In short, our findings suggest that, while returns are lower under high ESG compared to low ESG, returns are highest under low TA suggesting the potential presence of an ethically-driven decision made by impact investors using TA as an alternative measure.

4.2 Bivariate approach: pure impact investment strategy

In this study, we define pure impact strategy as one where an impact investor would select firms solely on the basis of impact factors such as ESG scores and the level of tax avoidance. Here, we assign portfolios into four categories: portfolios of firms with low ESG and low tax avoidance ( \(ESG_{L} \,\,\& \,\, TA_{L }\) ); portfolios of firms with low ESG and high tax avoidance \((ESG_{L} \,\,\& \,\,TA_{H}\) ); portfolios of firms with high ESG and low tax avoidance ( \(ESG_{H} \,\,\& \,\, TA_{L} )\) and portfolios of firms with high ESG and high tax avoidance ( \(ESG_{H} \,\,\& \,\, TA_{H} )\) . Table 3 reports the calculated BHARs under each category and their corresponding sample sizes. We also test for the statistical significance of the computed BHARs using single sample t test. The findings indicate that BHARs are positive and statistically significant across all categories and all time horizons for all portfolios consisting of firms with low ESG and high (low) tax avoidance. Although these portfolios offer a higher BHAR, an impact investor will not be attracted as these firms have low ESG scores and would be socially irresponsible.

Ideally, impact investors would invest in portfolios consisting of firms with high ESG and low TA \((ESG_{H} \,\,\& \,\,TA_{L}\) ). From columns 1–4 of Table 3 , short-term BHARs (1 month and 3-months period) and long-term BHARs (1 and 3 years) are positive and statistically significant of firms with high ESG and low TA. We also note that the combination of low ESG and low TA offers the highest returns (between about 0.3 and 24%). Although the returns under the pure impact combination \((ESG_{H} \,\,\& \,\, TA_{L} )\) are not the highest, the evidence shows that a pure impact investor can still earn a positive and reasonably high return.

Overall, our findings reveal that an impact investment strategy that embraces social responsibility based on ESG scores and TA would yield impact investors a BHAR of 3.4% per annum and 11.4% in the 3 years investment horizon. Conversely, an investment strategy based on portfolio of firms with low ESG and high TA may offer a far higher BHAR of 17.9% for the 3 years period but this approach does not constitute responsible investments.

4.3 Bivariate approach: combined impact investment strategy (ESG plus stock and market fundamentals)

Earlier, in Sect.  4.2 , we assessed the investment performance of a pure impact investment strategy based on ESG and TA only. This section analyses the investment performance when an investor combines impact variables such as ESG and TA with traditional investment strategies based on stock and market fundamentals including SIZE, PTBV, leverage and market risk.

Firstly, portfolio assignments are made on the basis of ESG scores and key firm and market fundamentals including SIZE, PTBV, leverage and market risk. The second portfolio assignments are based on TA and each of the stock fundamentals as mentioned above. We compute BHARs for each portfolio and test their statistical significance. Tables 4 and 5 report the findings.

4.3.1 ESG and size

Panel A of Table 4 reports the BHARs for portfolios ranked according to ESG and size. The findings suggest that returns are consistently positive across all groups and over different time horizons except for the combination of high ESG and small size for all time horizons. According to our findings, portfolio of small firms and firms with low ESG ( \(ESG_{L} \,\,\& \,\,Size_{S} )\) earn positive and significant BHARs for the 3-months, 1 year and 3 years periods. In the long run, for the 3 years time horizon, portfolios consisting of big firms and firms with low ESG ( \(ESG_{L} \,\,\& \,\, Size_{B }\) ) earn the highest BHAR (26.3%). However, an investor who is keen to invest in socially and environmentally responsible firms (ESGH) will not be interested to invest in this portfolio.

From our results, we can conclude that, for an investor who wants to combine impact with stock and market fundamentals, investing in portfolios consisting of big firms with high ESG ( \(ESG_{H} \,\,\& \,\, Size_{B }\) ) in the long run will earn the investor BHAR of about 14%.

4.3.2 ESG and PTBV

Panel B of Table 4 reports the BHARs for portfolios ranked according to ESG and PTBV. According to our findings, a portfolio consisting of low ESG firms with low or high PTBV earn positive and significant BHAR (2.6% and 40%). Although the return is extremely high, this will not be attractive to an impact investor.

For an impact investor, our findings show that portfolios consisting of firms with high ESG and high PTBV earn positive and significant BHAR across the short and long run with the highest BHAR of 21% in the 3 years investment horizon. This shows that, if an investor was to combine stock fundamentals with impact investing, firms with high ESG scores and high growth potential would offer investors the desired twin objective of socially responsible investment alongside a financial return.

4.3.3 ESG and leverage

Panel C of Table 4 provides the results for portfolios based on ESG and leverage. For portfolios consisting of low ESG and low leverage, the BHARs are positive and significant across all time horizons. In contrast, only the BHAR3Y is estimated to be a positive and statistically significant for low ESG and high leverage. Portfolios consisting of firms with low ESG and low leverage \((ESG_{L} \& Leverage_{L}\) ) earn the highest BHARs of 32% over a 3 years period. Once again, this combination will not appeal to an impact investor as firms have low ESG ratings.

From our results, we find that the BHARs are negative and not significant for portfolios consisting of firms with high leverage in the short run period (1 month and 3 months). However, the BHARs for these portfolios are positive and significant in the long run period (1 year and 3 years period). Portfolios consisting of firms with low leverage and both high and low ESG report positive and statistically significant BHARs ranging between 0.5 and 32% for low ESG and 0.3% and 16% for high ESG. Since the latter consists of firms with high ESG scores, impact investors would be interested in a portfolio of firms that are socially responsible and possess financial flexibility.

4.3.4 ESG and risk

Finally, Panel D of Table 4 presents the results for portfolios sorted according to ESG and market risk. For low risks portfolios, all BHARs are positive across all portfolios and time horizons irrespective of low ESG or high ESG. Although low ESG and low risk portfolios report the highest returns, a high ESG and low risk combination offers reasonably high returns ranging between 0.3 and 17.5%. A socially responsible investor will choose to invest in firms with high ESG and low risks with a BHAR of 17.5% in the 3 years period.

To summarise, based on our analysis above, our findings indicate that investors who combine impact with stock and market fundamentals will earn a higher BHAR (21.2%) in portfolio consisting of firms with high ESG and high PTBV. We can conclude that such a portfolio not only offers socially responsible investments but also provides an impact investor to invest in firms with high growth potential.

4.3.5 TA and size

Panel A of Table 5 reports the BHARs for portfolios ranked according to TA and size. The findings suggest that returns are consistently positive across all groups and over different time horizons. According to our findings, portfolios of small (big) firms and firms with high TA earn positive and significant BHARs for 1 year and 3 years horizons. In addition, BHARs in the short-term horizon are only statistically significant when firm size is big. According to our findings, an impact investor who is primarily interested in investing in socially responsible firms (TA L ) will make gains in big firms ranging between 0.3 and 19.6% for all time horizons. Gains in investing in small firms are only possible in a long-term horizon ranging between 4.9 and 15.4%.

4.3.6 TA and PTBV

Panel B of Table 5 reports the BHARs for portfolios ranked according to TA and PTBV. For all time horizons, portfolios consisting of firms with high (low) TA and low PTBV are all negative and mostly significant. On the other hand, for low (high) TA, BHARs are only positive when PTBV is high. The BHARs for these portfolios are only significant when TA is high, with returns ranging between 0.4 and 30%. Although the returns are reasonably high, they will not be attractive to an impact investor since firms are involved in high tax avoidance, which is socially irresponsible.

For an impact investor, our findings show that impact investors that choose a portfolio of low TA and high PTBV will earn a return of 29.8%.

4.3.7 TA and leverage

Panel C of Table 5 provides the results for portfolios based on TA and leverage. For portfolios consisting of low TA and low or high leverage, the BHARs are positive and significant across all time horizons, the highest return being 25.1% for portfolios with firms having low leverage in the long run.

For all portfolios consisting of firms with high TA and low levered firms, the BHARs are positive with the highest BHARs of 24.3% over a 3 years period. This combination will not appeal to an impact investor interested in socially responsible investment portfolios.

Our results indicate that, in the long run, a socially responsible portfolio consisting of low tax avoidance and low leverage firms will yield a higher BHAR (25.1%) compared to firms engaging in high tax avoidance (24%). This fulfils the objectives of a socially responsible investor and ensures lower bankruptcy costs at the same time.

4.3.8 TA and risk

Finally, Panel D of Table 5 presents the results for portfolios sorted according to TA and risk. All BHARs are positive and significant across all portfolios consisting of low TA and high or low risks across all time horizons. For portfolios with firms with low TA and high/low risk, the highest BHAR is 22% in the 3 years period. Since this investment involves investing in socially responsible firms, the impact investor will be drawn to investing in this portfolio.

To sum up, based on our analysis above, our findings indicate that socially responsible investors will earn a higher BHAR (29.8%) in a portfolio consisting of firms with low TA and high PTBV. We can conclude that investors that combine socially responsible firms and firms with high growth opportunities in a portfolio will earn a higher return.

On a relative performance analysis of the various investment strategies undertaken above, we find that a pure impact strategy of high ESG and low TA offers a BHAR of 11.4% in a 3 years investment period. On the other hand, a mixed or combined investment strategy of impact plus firm and market fundamentals provides a return of 21.2% for portfolios of firms with high ESG and high PTBV; and a BHAR of 29.8% on portfolios of firms consisting of low TA and high PTBV.

An impact investor who is committed to investing in only socially responsible firms ( pure impact investment strategy) can earn a BHAR of 11.4% in a 3 years investment period; this study also shows that, over the same time horizon, impact investors can choose a portfolio based on low tax avoidance instead of ESG scores as an impact variable.

4.4 Panel regression results

4.4.1 portfolio selection regression results.

In this section, we discuss the regression results on the effect of portfolio selection on returns using linear regression. Linear regression, as stated previously, is the standard tool used in the literature to show the marginal effect of ESG and TA, amongst other key factors of interest on the performance of an investment. In this context, we estimate various specifications using various models including pooled OLS, Fixed Effect and Random Effects models. We, however, restrict our discussions on the findings based on the MLM model. First, the qualitative conclusions based on the previous models are no different from those found by the MLM. Footnote 12 Second, we argue that the MLM model is the most appropriate model since it allows for more than two levels of random effects and fixed effects.

Table 6 reports the estimates of the MLM allowing for ESG only as a portfolio selection criterion. Full sample estimates refer to the case when there is no portfolio selection. The ESG slope is found to be negative and statistically negative for BHARs except the 1-month BHAR. The low ESG and high ESG report the estimates of the model using ESG portfolio selection. The negative relation between ESG and BHARs is consistent with those reported in the correlation matrix in Panel B of Table 1 . In other words, low and high ESG estimates report negative effect on BHARs. The effects are statistically significant for low ESG across all time horizons and mostly insignificant for high ESG (except for the 3 years period). A plausible explanation for this finding may be due to the longer period required for ESG practices to be fully integrated into the firm for it to yield a positive return (Cappucci 2018 ).

Table 7 reports the estimates of the MLM using TA as a portfolio selection criterion. Similarly to using ESG as criterion, we compare subsamples estimates to the full sample. The full sample estimates refer to the case when there is no portfolio selection and accounting for tax avoidance effect. In other words, we restrict the ESG coefficient to zero since the investor is assumed to use only TA as a selection criterion. The effect of CETR Footnote 13 on 1-month, 3-months, and 1 year BHARs is positive and statistically significant when using the full sample. Under high TA, the effect of CETR is positive and significant only for the long-term returns. Under low TA, however, CETR has a positive and statistically significant effect on 1-month, 3-months and 1 year BHARs. So, a socially responsible investor can create portfolios based on firms with low TA (high CETR) as a measure for choosing impact investment.

Finally, we extend the analysis by accounting for the bivariate portfolio selection, which combines both ESG and CETR. In this context, we estimate a full sample-based model including ESG, TA and the interaction of ESG and CETR. Table 8 reports the MLM estimates. In general, there is very limited evidence that suggests the presence of a statistically significant effect of impact investing captured by the three variables ESG, CETR and the interaction of ESG and CETR. The Wald test for the joint significance of these three variables is rejected for all BHARs except the 3 years BHAR. The estimated effects of ESG are negative and statistically significant for all BHARs, while CETR and the interaction term are not statistically significant.

Tables 9 , 10 , 11 and 12 account for portfolio selection using the high-low ESG-TA combined criterion, which produced four subsamples. We note that there is no strong evidence in favour of individual statistical evidence of the variables ESG, CETR and their interactions ESG × CETR. In addition, there is lack of evidence of consistently estimated correct signs across these subsamples. The joint significance Wald test reports strong evidence in favour of the presence of impact investing for the portfolio with high ESG and low TA. Estimated returns, however, are negative except for 3 years BHARs, which is significant.

4.4.2 Portfolio performance regression results

We use causal effects models to capture the true effect of portfolio selection on the conditional average returns. The portfolio selection criteria are defined as treatment variables. The BHARs are estimated based on Eq. ( 11A –C). Table 13 reports the estimated average BAHRs given a randomly selected investor chooses a particular portfolio combination. We use three estimators for robustness check, including regression adjustment (RA), augmented inverse probability weighting (AIPW) and inverse probability weighting regression adjustment (IPWRA).

The findings suggest that, for high TA-based portfolios, the estimated conditional returns are only statistically significant for 1 year and 3 years, ranging from 2.7 to 19.1%. Low ESG and low TA reports estimated BHARs ranging between 0.26 and 21.4%, while high ESG and low TA reports estimated BHARs ranging between 0.3 and 9% positive. The low TA-based portfolio reported better BHARs performance than the high TA portfolios.

Table 14 reports the estimated alphas for the factors models specified in Eqs. (12A–C). Our findings suggest that, for all univariate and bivariate portfolios, the estimated alpha is negative and statistically significant. This indicates that the portfolios have underperformed. This evidence corroborates the findings of Barber et al. ( 2021 ) who find that impact investors are willing to earn a lower financial return for their investments that have a societal impact and conclude that lower return implies lower cost of capital.

4.5 Discussion of empirical results

In this paper, we integrate the empirical association between corporate social responsibility (CSR) and tax avoidance into an investment strategy based on impact. Due to the lack of standardisation in ESG reporting, this measure may not be a reliable source for an impact investor to choose responsible firms. We propose an additional measure of tax avoidance to identify firms that are socially responsible. When firms indulge in excessive tax avoidance behaviour, it may be viewed as unethical or socially irresponsible. An impact investor will look for a positive return when engaging in a responsible investment strategy. Therefore, a wide range of econometric and statistical testing is necessary to cover a wider range of possibilities; those that have yet to be attempted in the literature.

We employ various statistical methods to test whether impact investing is an optimal investment strategy for investors. Standard literature (Lee et al. 2013; Eccles et al. 2014 ; Dorfleitner et al. 2015; Tosun 2017 ; Adegbite et al. 2019 ) emphasise the role of ESG as a measure of responsible and ethical investing. The empirical literature, however, is not conclusive on the validity of this role due to various reasons. For example, Cappucci ( 2018 ) offers a comprehensive and critical review on the shortcomings of using ESG arguing that the presence of ESG policies does not necessarily reflect firms’ commitments to sustainable finance. Other studies, including Liang et al. ( 2020 ) and Lopez et al. ( 2020 ), raise the issue of lack of global standardisation of the ESG measures. Ayton et al. ( 2022 ) show that THE frequency of which ESG scores are measured may also affect its role in explaining firms’ performance.

In this context, our findings are not different from those in the literature cited above. For example, the univariate exercise reported in Table 2 shows that firms with low ESG have higher BHARs than those with high ESG. Furthermore, regression-based analysis reported in Table 6 shows that ESG has a negative marginal effect on BHARs in the long run. The possible explanations for this finding can be the lack of global standards on ESG reporting and measuring which can lead to the use of additional impact measures by investors.

From the statistical and econometric perspective, ESG scores tend to remain stable at around the same levels for many years, while firm performance tends to vary over time. It is as if one is regressing a highly volatile variable on another constant, leading to lack of variations and, therefore, leading to potentially insignificant results. This also implies that investors may not use the ESG variable to update their decisions since the ESG scores do not often change. Ayton et al ( 2022 ) show that, when ESG is measured using monthly data, the variability within the ESG would co-move with that of firms’ performance, leading to a significant role of ESG on firms’ performance. This is an additional reason as to the need for an additional measure for impact investors to use.

Hence, in this study, we propose TA as an additional impact measure to capture responsible and ethical practices. Our findings show that TA is a reliable impact measure. Based on Table 2 , we note that low TA leads to positive and reasonably high returns and Table 7 regressions output show that low TA has a positive and statistically significant effect on the 1-month, 3-montha and 1 year BHARs.

Thus, in this study, we combine ESG and TA to construct investment portfolios using a four-combination measure of impact investing: low ESG–low TA, high ESG–low TA, low ESG–high TA and high ESG–high TA. A pure impact investment strategy should be based on high ESG–low TA. In this context, we test this using various methods. The simplest approach is to compute and test the significance of returns for each category. As reported in Table 3 , a pure impact strategy leads to returns between 0.3 and 11.4%. At the time, we find that a low ESG-low TA leads to higher returns overall, between 0.3 and 24%. Drawing from the discussion above and from our findings, we can conclude that TA is very likely the driver of responsible investing more so than ESG.

We also show, using potential outcome models, that the ESG-TA combinations across portfolios cause varying results. The evidence shown in Table 13 implies two key conclusions. First, ESG and TA combined have causal effects on investors’ returns. Second, the main driver of these causal effects is low TA. ESG when combined with high TA does not cause any effect on short-term BHARs including 1 year BHAR (for high ESG–high TA combination). On the other hand, low TA combined with both low and high ESG results in positive and statistically significant returns ranging between about 0.3 and 21% (for low TA–low ESG) and 0.3 and 9% (for low TA–high ESG). This is consistent with the argument that ESG may be used to attain positive long-term returns only (Cuppuci 2018 ). Therefore, we suggest that TA is an additional measure that responsible investors can rely on to form their portfolios based on impact criterion.

5 Conclusion

The primary goal of this paper is to explore and recommend an investment strategy based on impact criterion. Due to the lack of standardisation in disclosure and reporting of ESG ratings by firms (Amel-Zadeh et al. 2018 ; Gibson et al. 2019 ; Berg et al. 2020 ), it becomes necessary to explore an additional measure. Given the negative association between CSR and tax avoidance, we argue that tax avoidance can be used as an investment criterion for impact investing. Firms may argue that, by reducing their tax expense, the savings can be used for socially responsible initiatives. However, this argument becomes very challenging to capture, given the inconsistencies in the disclosure and reporting of such initiatives as well as the ambiguous reporting of TA in the ESG score. This is one of the first studies, to our knowledge, to empirically relate tax avoidance and ESG ratings in impact investing. We find that, in a pure impact investment strategy based on ESG and tax avoidance, investing in high‐ESG rated firms and low tax avoidance firms yields a buy and hold abnormal return of 3.4% per annum and 11.4% in a 3 years investment horizon. Next, if impact investors were to combine traditional investment strategies based on firm fundamentals with impact factors, we find that portfolios of high‐ESG and high price‐to‐book‐ratio firms earn 21.2%, returns, while a portfolio of low tax avoidance and high price-to-book portfolios earns 29.8% in the long run. Finally, we apply a causal effect model as an alternative to regression models. Portfolio performance evaluation regression results show that a pure impact strategy remains a profitable option as it results in positive and relatively acceptable average returns ranging between 0.3 and 9%.

The contributions of our study are four-fold; first, to our knowledge, this is the first study that introduces tax avoidance as an additional impact measure as existing ESG measures use varying methodologies (Berg et al. 2020 ) as well as unstandardised ESG reporting by corporates. Hence, ESG scores can be unpredictable and may not truly reflect corporate social responsibility appropriately. This study argues that the TA variable can be used to overcome the limitations of ESG as an additional impact measure. It can enable analysts and impact investors to evaluate corporate social responsibility initiatives of firms. Second, this is the first study that assesses an investment strategy based on impact using risk-adjusted returns across varying investment horizons; next, this study also evaluates investment strategy that combines impact variables with firm and market fundamentals. Lastly, the findings from this paper can help institutional investors, and the investment community, to use this additional measure of TA for better evaluation of their investment policies.

Our study has the following policy implications. The use of tax avoidance as an impact measure can help policy makers and regulators to understand the scope and prevalence of corporate tax avoidance practices in firms. This can facilitate framing of policies and guidelines in terms of improved disclosure and reporting. Targeted anti-tax avoidance policies will lead to better transparency and encourage firms to be more socially responsible. Hence, investment strategy based on TA can lead to a positive return together with better social impact.

The limitation of this study is the fact that, while we can assess the investment performance of an impact investment strategy, we are unable to measure the impact or extent by which these impact investments generate a positive, measurable social and environmental impact. Future studies could explore this aspect of impact investing. This study also limits its focus to equities; future work could encompass other asset classes such as fixed income and commodities. Until such time that ESG reporting and disclosure are standardised globally, the search of a holy grail of additional impact measures is imperative and critical, especially since impact investing is set to grow and gain momentum in the coming years.

The tax gap is the difference between the amount of tax that should, in theory, be paid to HMRC, and what is actually paid. The avoidance tax gap represent loss in tax revenue from tax advantage not intended by the Act.

We also use book tax differences as an additional measure for tax avoidance. Results do not change and are available upon request.

We do not consider the means adopted by firms to indulge in excessive tax avoidance as it falls outside the scope of this study.

CETR below the median.

See Appendix 1 .

We also use book tax differences as an alternate measure for tax avoidance.

Using actual cash tax paid instead of total or current tax expense makes the measure more robust (Hanlon 2003 ; Dyreng et al. 2008 ; Chen et al. 2010 ).

The median is computed for any given variable x as follows: \(Med\left( x \right) = \left\{ {\begin{array}{*{20}l} {x\left[ \frac{n}{2} \right],} \hfill & { for \,\,even\,\, n} \hfill \\ {\frac{{x\left[ {\frac{n - 1}{2}} \right] + x\left[ {\frac{n + 1}{2}} \right]}}{2}, } \hfill & {for\,\, odd\, n} \hfill \\ \end{array} } \right.\) , where n is the sample size.

We repeat the estimations with book tax differences and results do not change.

The Fama–French factors are available at Kenneth French’s website ( https://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html ).

We implemented t test for the partially paired samples to test the null that the average BHARs of group A is the same as BHARs of group B.

The results are available upon request.

High values of CETR denotes low TA and low values of CETR denotes high TA.

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Acknowledgements

We would like to thank participants of the International Finance and Banking Society Conference 2021 and the Finance and Accounting 2022 Annual Research Symposium for helpful comments and suggestions. We also thank Tony Bradly, Fatima Shuwaikh, Yanru Han, Marwan Izzeldin, Ishan Kapur, Prem Puwanenthiren and Sobia Razzaq for their insightful comments on earlier versions of this paper.

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Juddoo, K., Malki, I., Mathew, S. et al. An impact investment strategy. Rev Quant Finan Acc 61 , 177–211 (2023). https://doi.org/10.1007/s11156-023-01149-0

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Accepted : 05 March 2023

Published : 05 April 2023

Issue Date : July 2023

DOI : https://doi.org/10.1007/s11156-023-01149-0

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When Does Impact Investing Make the Biggest Impact?

The idea of supporting social change has propelled impact investing assets to more than $1 trillion. But what if those funds aren’t as impactful as investors expect?

Recent Harvard Business School research indicates that while impact investors do behave differently in some important ways, the vast majority tend to invest in companies that are also able to raise capital from non-impact investors. More than half of funding rounds involving impact investors include co-investment with traditional, profit-motivated investors.

The study finds impact investors are more likely to invest in disadvantaged geographies and nascent industries, and they exhibit more risk tolerance and patience. However, the authors also find employee satisfaction tends to decline once an impact investment is made.

“In their mind, if they give a company $1 million equity investment, when nobody else was willing to do that, then that company has more capital and can do things that it couldn't otherwise do.”

Doing well by doing good is an important trend in business generally and venture capital specifically, with the sphere of impact investing no longer niche as big players like Bain Capital and BlackRock dive in. One important question the HBS study tackles carefully is the question of "additionality"—would the portfolio companies of impact investors have been able to raise capital from traditional investors, or might they have been passed over because of their increased risk?

“Some impact investors care a lot about additionality. In their mind, if they give a company $1 million equity investment, when nobody else was willing to do that, then that company has more capital and can do things that it couldn't otherwise do,” explains Shawn Cole, the John G. McLean Professor at HBS, who is one of the study’s authors. “But, if there were 20 other venture capital funds that would have been just as happy to give $1 million to that firm, then the capital isn’t additional. This seems to be the case for the majority of the portfolio companies we identify.”

However, Cole pointed out there are different approaches to impact investing. “Most of the dollars raised are deployed in funds seeking market returns, and many of those investors are quite happy to co-invest with traditional venture firms.” Impact investors may seek to influence portfolio companies in other ways.

Cole conducted the research with HBS colleagues Leslie Jeng, senior lecturer; Josh Lerner, Jacob H. Schiff Professor; Natalia Rigol, assistant professor; and Benjamin N. Roth, Purnima Puri and Richard Barrera Associate Professor.

A year-long database build

Because no truly comprehensive database for impact investing exists, the authors spent more than a year creating their own by compiling nine databases and lists. The authors then set out to track and compare companies and their basic characteristics.

After filtering through 2,747 potential impact investors, the authors wound up with 396 impact investors for their analysis. They looked for language that was more specific than “make the world a better place” and included big players like TPG Alternative & Renewable Technologies.

Using US census data, the researchers cross-referenced portfolio companies, finding some 84 percent matched. They also cross-referenced US impact investing companies with data from Revelio Labs, for an 83 percent match rate, to study what effect the investments had on target companies.

Additional value to traditional investing?

The key finding: Impact investment funds mostly buy stakes in companies that traditional financiers would have funded anyway.

Impact investors funded 6,066 firms in 8,125 rounds, representing about 2 percent of all venture capital and growth equity rounds, the authors show. Of the more than 8,000 deals, 60 percent include a traditional private co-investor.

“The takeaway is that the difference is not as large as you might think.”

Both traditional and impact investors had similar portfolio sizes, with roughly 24 companies with 31 investments each, and had operated for about a decade on average. Impact investor deals averaged about $5 million, lower than traditional investments of about $8.7 million.

“The takeaway is that the difference is not as large as you might think,” Cole says. “As an investor, you have a bit of a strategic choice.”

Where impact investing makes the most impact

Impact investors approach targets differently than traditional firms, the authors note. They focus on disadvantaged regions and emerging industries, allow for longer time horizons, and take more risk than traditional investors.

Impact funds tend to prioritize consumer staples, energy, financials, industrials, materials, real estate, and utilities. Impact investors, on average, target investments in countries with 23 percent less economic output—$9,400 per capita—than those of mainstream companies. Impact-only investments may require more patience, with a roughly 25 percent longer time to reach success.

“It's not simply greenwashing in the sense that there are real differences between impact investing and non-impact investing,” Cole says. “But it’s a matter of degree.”

Areas for further research

The researchers found that employee satisfaction dropped twice as much when impact investors bought a stake in a company, compared to the decline after a traditional investment. That may cast some doubt on the social benefits of impact investing at early stages and deserves further study, they note.

The study also suggests that impact investments might benefit companies that can’t raise funds through mainstream channels most, the researchers say.

Reporting on impact investing is fast evolving. “There are a lot of really important questions that are hard,” Cole says. “Quite frankly, they may not even be answered in the venture capitalist space. Questions like ‘what are best practices for impact investing?’ Our hope is that these data allow us and other researchers to begin to shed more light on this important sector.”

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Protect Our Earth With 5 ETF & Stock Investing Strategies

Today marks the 54th year of Earth Day observations. The day honors the importance of conservation initiatives to protect the environment. Global warming has now become a burning issue, raising awareness among mankind.

So long it has been believed that global warming leads to climate change causing drought in one region and flood in others. But as an eye-opener, economists have come up with the theory that global warming can cause job losses, recessions and even a tumbling stock market.

This makes it important for investors to be socially responsive while creating their investment portfolio. Let’s take a look what’s hot and what’s not on the occasion of Earth Day. Investing with a focus on Earth Day involves considering companies and funds that prioritize environmental sustainability and responsibility. Here are some ETF and stock investing strategies for Earth Day:

Renewable Energy

 Look for stocks and ETFs that invest in companies involved in renewable energy sources such as solar, wind, hydroelectric, and geothermal power. These ETFs often include companies engaged in manufacturing solar panels, wind turbines, and other renewable energy technologies.

Zaks Rank #1 (Strong Buy) Nextracker Inc. ( NXT Quick Quote NXT - Free Report ) is a provider of intelligent, integrated solar tracker and software solutions used in utility-scale and distributed generation solar power plants.

Zaks Rank #3 (Hold) Invesco Solar ETF ( TAN Quick Quote TAN - Free Report ) is comprised of companies in the solar energy industry. The fund charges 67 bps in fees.

Water Management Investing

Invest in companies involved in water conservation, purification, and distribution. These companies play a crucial role in addressing water scarcity and ensuring access to clean water, which is essential for both human well-being and ecosystem health. As the global population grows and the global water crisis is intensifying, this thematic investment avenue emerges.

Zacks Rank #2 California Water Service Group ( CWT Quick Quote CWT - Free Report ) is one of the largest investor-owned water utilities in the United States. Along with its units, it provides regulated and non-regulated high-quality water and wastewater services to nearly 2 million people.

Zacks Rank #2 Invesco Water Resources ETF ( PHO Quick Quote PHO - Free Report ) tracks the performance of US exchange-listed companies that create products designed to conserve and purify water for homes, businesses and industries.

Disaster Recovery Strategy

Investing in stocks related to disaster recovery in can be a strategic idea given the rise global warming and other natural calamities. Companies that provide essential services or products during and after natural disasters fall in this category.

Notably, companies that specialize in repairing or rebuilding roads, bridges, and buildings can be crucial after events like hurricanes, earthquakes, or floods. Zacks Rank #1 (Strong Buy) Sterling Infrastructure Inc. ( STRL Quick Quote STRL - Free Report ) operates through subsidiaries within segments specializing in E-Infrastructure, Building and Transportation Solutions principally in the United States.

Procure Disaster Recovery Strategy ETF ( FIXT Quick Quote FIXT - Free Report ) consists of globally listed stocks and depositary receipts. The fund charges 75 bps in fees.

ESG (Environmental, Social, and Governance)

Since the overall wellbeing of this planet should be remembered on this occasion, a focus on ESG (environmental, social and governance) investing should be pivotal. About 50 ETFs holding $86.7 billion employ ESG guidelines, according to etf.com data. 

Agreed, ESG investing has underperformed lately due to too many political implications, but retail investors exhibit reduced polarization regarding investment in accordance with ESG principles. ETFs that typically invest in companies with strong sustainability practices and positive environmental footprints are good options here.

Zacks Rank #3 Microsoft Corp. ( MSFT Quick Quote MSFT - Free Report ) is known for its commitment to becoming carbon negative by 2030, Microsoft also invests in sustainable data centers and renewable energy. Microsoft wants to achieve 100 percent renewable energy consumption by 2025.

iShares ESG Aware MSCI USA ETF ( ESGU Quick Quote ESGU - Free Report ) comprises of U.S. companies that have positive ESG characteristics while exhibiting risk and return characteristics similar to those of the parent index. The Zacks Rank #3 fund charges 15 bps in fees.

Carbon Strategy

As summer heats up, so does the carbon market. Carbon allowances have been on a steady upward climb lately. Cap-and-trade markets issue carbon allowances equivalent to one ton of carbon dioxide. Participants must account for their emissions at the end of each year through an equivalent amount of carbon allowances. As countries strive to reduce emissions, carbon allowances stand to benefit

Most major carbon allowance markets have built-in tightening mechanisms that decrease the supply of allowances over time. The combination of a reduced supply and increasing demand is likely to exert upward pressure on the price of carbon allowances in the years to come.

KraneShares Global Carbon Strategy ETF ( KRBN Quick Quote KRBN - Free Report ) tracks the most liquid segment of the tradable carbon credit futures markets.

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How life insurers can provide differentiated retirement benefits

EY Americas Retirement Leader Principal, Ernst & Young LLP

Related topics

Benefits of integrating insurance products into a retirement plan (pdf), permanent life insurance and deferred income annuities with increasing income potential outperform investment-only approaches in our analysis..

• By 2030, gaps in investors’ retirement savings and needed protections are projected to exceed hundreds of trillions of dollars in the US.
• This presents an opportunity for insurance companies to better serve customers to bridge these chasms, through modified investment approaches.

A lthough facing challenges, the US life insurance and retirement industry has enormous potential to grow. Our analysis reveals insights on how best to capitalize on this opportunity.

EY researchers estimate that by 2030, there will be a $240 trillion retirement savings gap and a $160 trillion protection gap. Insurers are uniquely positioned to address these gaps with products that offer legacy protection, tax-deferred savings growth and guaranteed income for life.

In this article, we explore how two products can be used to meet investors’ savings and protection needs: permanent life insurance  (PLI) and a deferred income annuity with increasing income potential (DIA with IIP), which represents deferred income annuities with persistency bonuses and non-guaranteed dividends. Can integrating PLI and a DIA with IIP into a retirement plan provide value beyond an investment-only strategy?

It is a complex question to answer. To judge the impact of PLI and DIAs with IIP, we analyzed five strategies, conducted across three different starting ages: 25, 35 and 45. For each strategy, our Monte Carlo analysis generated 1,000 scenarios based on randomized input from a range of factors, such as interest rates, inflation rates, equity returns and bond returns. The high-level results are shown in this summary article and elaborated upon in our full report.

Download the full report

The five strategies compared.

We examined a baseline of traditional investment strategies and then compared them against those that also factor in PLI and DIAs with IIP:

For strategies that include PLI and a DIA with IIP, the value of these products is included in the total financial assets and considered part of the fixed income allocation. Thus, for strategies where an investor allocates a portion of their wealth to an insurance product, the amount invested in bonds decreases compared to the investment-only strategy.

In our analysis, PLI cash value (accessed via surrenders or loans) are used to fund retirement income during periods of market volatility, allowing investors to avoid liquidating assets from their traditional investments that have fallen in value.

We divided the investor’s assets between the investments and the insurance products. Different product allocation combinations were simulated in increments of 10% of total annual savings for PLI and projected wealth at age 55 for DIA with IIP. Allocation percentages were capped at 60% for PLI and 30% for DIAs with IIP. For each allocation combination, we calculated the after tax retirement income that an investor can sustain in over 90% of the market return scenarios.  We also calculated the legacy value at the end of the time horizon. 

The benefit to investors

Following this methodology, strategies involving PLI and DIAs with IIP excelled overall against investment-only approaches — although the implications must be couched in a bit of nuance, depending on whether the investor is focused more on retirement income than legacy. Here are six key insights on how the strategies compare:

1. PLI + investments strategies outperform investment-only and term life + investments strategies.

PLI tends to provide superior returns over fixed income in long-run scenarios, while the term premium acts as a drag on portfolio performance. PLI loans act as a buffer against market volatility as well, improving returns since the investor does not have to sell and realize losses on investments. 

2. DIA with IIP + investments strategies outperform other strategies in retirement income.

With DIAs with IIP + investments, the investor uses a portion of the balance to purchase the DIA with IIP and does not receive that balance upon death, boosting retirement income compared to other strategies. Projected legacy tends to be lower than PLI + investments but higher than the legacy from the investment-only strategy. The latter observation is a result of the DIA with IIP outperforming fixed income due to mortality credits and dividends.

3. Integrated strategies are more efficient than investment-only strategies.

For example, a strategy allocating 30% of annual savings to PLI and 30% of assets at age 55 to a DIA with IIP produced 5% higher retirement income and 19% more legacy than the investment-only strategy, because PLI and DIA with IIP both outperform fixed income. 

4. For investors with a higher risk appetite, integrated strategies remain better. 

We performed the same exercise described above, except that we calculated the retirement income (and legacy values) based on the amount that the investor can sustain in over 75% of the market return scenarios, reflecting the expectations of an investor with higher risk. Income and legacy do not improve as much, yet an integrated portfolio still provides benefits relative to an investment-only strategy.

5. Integrated strategies provide investors with the flexibility to focus on the financial outcomes most important to them: retirement income, legacy or a balance in between.

 We found that PLI and a DIA with IIP mix well together, whether a person is focused on retirement income, legacy or a balance. Higher allocations to a DIA with IIP emphasize retirement income, while higher PLI boosts legacy protection. The right mix depends on the investor’s preferences.

6. Allocation up to 30% of annual savings to PLI and up to 30% of wealth at age 55 to DIA with IIP may be appropriate when optimizing retirement income and legacy value outcomes. 

Results varied by investor starting age. But the projected retirement income and legacy values generally supported allocations of 10% to 30% to both PLI and DIAs with IIPs. An investor solely focused on maximizing legacy may still opt to allocate more to PLI, but when that allocation redirects too many assets away from equities, the reduction to retirement income can be substantial.

The results point to the value of PLI and DIAs with IIPs in a retirement plan: an integrated approach can give comfort and peace of mind to retirement investors by providing legacy protection, tax-deferred savings growth, and guaranteed income for life without sacrificing their present lifestyle. Insurers can use these products to strengthen their relationships with investors, seizing upon the possibilities in a marketplace that has proved challenging.

This article has been authored by Christopher Raham, Justin Singer, Ben Yahr, Ben Lee, and Annie E Mayer.

Investment-only approaches do not deliver as promising returns as those that are combined with PLI and DIAs with increasing income potential, an EY analysis shows, although there are distinctions to consider depending on whether more retirement income or legacy value is desired. Allocation levels should be approached with care.

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• Leaders prioritize investments in three areas: operational improvements; big data, AI, and analytics; and e-commerce.
• Within e-commerce, they’re prioritizing investing in retail media networks, marketplaces, and social commerce.
• Innovation leaders take a bold approach, shifting customer expectations rather than following trends; accelerating their activities by collaborating with third parties and acquiring capabilities; and investing in multiple initiatives at once.

Subscribe for more insights on the retail industry

Retail Industry

/ report, the innovation edge for retailers.

By  Chris Biggs ,  Khaled Tawfik ,  Jennifer Aylwin ,  Tanmay Jain ,  Daniel Gospodinov , and  Allison Zeller

Key Takeaways

Social channels where a shopper can buy something with a single click. GenAI -assisted shopping. Virtual stores in the metaverse. Hyper-personalized, gamified experiences embedded in shopping journeys. Near-instant delivery.

Retailers are innovating more and faster to keep pace with changing consumer behaviors and preferences. Innovation gives them an edge, a key source of competitive advantage and resilience. According to new research from BCG and the World Retail Congress, retailers with industry-leading innovation practices perform markedly better than their peers.

Our survey of more than 400 executives from a cross-section of retail sectors worldwide found that innovation leaders invest significantly more in innovation and achieve a higher ROI. (See Exhibit 1.)

Investing in Innovation

According to our research, both retail innovation leaders and laggards expect to increase how much they invest in innovation in the next three years; leaders anticipate spending 38% more, while laggards will spend only 8%.

Leaders prioritize innovation investments in three areas: operational improvements; big data , AI, and analytics, and e-commerce. (See Exhibit 2.)

Operational Improvements

Retail executives are addressing cost pressures across their value chains by investing in process innovation and automation to improve and streamline operations. They often pass part of the resulting savings to increasingly value-driven consumers.

Big Data, AI, and Analytics

Leaders are developing roadmaps for targeted big data and AI use cases to drive significant changes in top- and bottom-line growth. Many are experimenting with GenAI to prove its value for creative content, customer support, and administrative and operational tasks, among other areas.

Retailers are embracing new forms of e-commerce to meet consumers’ increasingly sophisticated needs, grow gross merchandising value (GMV), and improve profitability. Innovation leaders are investing in the following areas in particular.

Retail Media. Inventive retailers set up retail media networks so brands and other third parties can buy advertising space on the retailers’ owned properties, including stores, websites, and apps. Retailers use the data they gain from their close proximity to customers to offer targeted, high-conversion advertising opportunities to suppliers and other companies. In return, they earn margins of up to 60% or 70% of collected advertising revenue, significantly higher than traditional retail margins. One way companies with mature networks are expanding their activities even further is by selling ad space offsite, including programmatically across the web and on social media. They’re also giving advertisers the ability to target specific customer audiences to generate better returns on advertising spend (ROAS) and visibility into the impact through sophisticated measurement tools. And they’re offering advertising services to companies beyond their existing suppliers.

Marketplaces. More than four in ten innovation leaders in our survey have invested in marketplaces, the online platforms that let them collect commissions on goods listed and sold by third parties. Marketplaces help retailers quickly scale their range of products while simplifying internal operations; generating rich, insightful data; and driving superior profitability and ROI. This advantage helps explain why marketplaces have become the prevalent business model in retail e-commerce, generating more than two-thirds of all e-commerce sales. However, these platforms remain a relatively new phenomenon. In many geographies, there are no well-established marketplaces in many product categories—which opens up opportunities for first movers to scale quickly. Innovative retailers are taking their marketplace ventures a step further, creating platforms that are category-specific, offer low prices, or blend games and entertainment with buying.

Social Commerce. The convergence of social media and e-commerce enables brands, influencers, and other sellers to pitch products directly on social platforms in an engaging way, creating stronger shopper interest and higher conversion rates. Social commerce is more prevalent in the East, and covers a variety of emerging formats, including livestreaming and group purchasing opportunities. In China, social commerce already accounts for one out of five e-commerce purchases, and continues to grow. It’s also picking up steam in the West.

Retail Innovation Success Factors

Innovation leaders adopt a bold approach. They use innovation to shift customer expectations rather than launching initiatives solely according to what customer say they want. They identify areas where they can accelerate innovation by augmenting internal operations with external capabilities, including by collaborating with third parties and acquiring new capabilities. And they maximize their anticipated ROI by investing in multiple innovation initiatives at a time rather than focusing on one or two.

In addition, leaders’ winning approach is built on six success factors that separate their performance from that of other retailers. They align priority innovation areas with strategic goals; build a culture that fosters grassroots innovation, and invest in modern modular technology and data infrastructure. They also establish innovation teams and agile ways of working, adopt a risk assessment framework that allows them to take on higher-risk experiments and projects, and establish a dedicated innovation budget and governance.

Managing Director & Senior Partner; Global Leader, Retail Sector

Managing Director & Partner

Retail Strategy Expert

Washington, DC

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