An impact investment strategy

Abstract

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.