Impact investments—the term used to describe investments that simultaneously achieve a financial return and measurable social impact—are all the rage among the socially conscious. Multitudes of companies claim to undertake impact investments, dozens of conferences are devoted to the asset class, and countless op-eds and articles are clamoring that impact investments are “game changers.”

Recent efforts, such as Kim Tan’s “Impact Investing: Time for a New Terminology?” article, have meanwhile attempted to distinguish true impact investments from intentionally mislabeled ordinary investments. We think that the increasingly popular label “impact investor”—a term attractive to foundations, managed funds, and individuals alike—is also abused.

Being an impact investor implies a sense of altruism in the face of greedy financial markets, and this distinction has tremendous marketing and reputational value. What the term lacks is a definitive meaning. A so-called impact investor may say something like, “I invest in companies that are intentionally furthering a social goal, and simultaneously I am earning a financial return.” What he won’t tell you is whether he is what we call a FLII (a free lunch impact investor) or a PII (a philanthropic impact investor)—and the difference is important.

A Simple Thought Experiment

Suppose an investor has the opportunity to invest in a project that will earn him more than an appropriate return—the opportunity cost of his capital—given the project’s risks. Clearly, the investor will find the project attractive and will invest. If the project also produces a valuable social good, that’s icing on the cake.

These are exactly the types of investment opportunities that FLIIs are looking for—they earn a fair return, and the investment also produces social good. They pat themselves on the back for “doing good,” but there is nothing fundamentally meritorious about their actions. After all, they are not unlike other niche investors, who for example invest only in technology or in companies that start with the letter A. They have a strong affinity for investing in companies that are oriented toward a social goal, but they demand market returns. FLIIs are not willing to make any sacrifice (except perhaps some portfolio diversification) to further a social goal.

Now suppose an investor has the opportunity to invest in a different project, one that will not earn him the opportunity cost of his capital. From solely a profit-motivated perspective, the investment is not particularly attractive. But suppose that this project also produces social good valued by the investor and that the investor’s appreciation of that exceeds the financial losses. What can we say about these types of investments?

These investments are meant for PIIs, who understand and appreciate that furthering a social goal may come at the expense of maximizing profits. As such, PIIs are willing to forsake some financial gain if it means furthering a cause they believe is important.

Silencing the Critics

FLIIs will be quick to object to this distinction. They will provide evidence of investments that have performed well as proof that impact investments outperform the market and that “doing well while doing good” is prevalent.

Certainly there are investments that further a social goal while maximizing profit—but they don’t need impact investors. Even if you believe in the mildest forms of market efficiency, it is obvious that investors who care less about social good will find those same investments attractive.

PIIs are aware that they may earn below-market returns but believe that their investments play a meaningful role in furthering important social goals. And by investing in opportunities that won’t appeal to investors who are solely profit-motivated, they fulfill a need that traditional market forces cannot satisfy.

The G8’s recently published “Report of the Social Impact Investment Taskforce” lauds this paradigm shift from the traditional “risk-return” view of investing to the new trifurcation of “risk-return-impact.” However, one needs to closely consider the paradigm’s implications.  In the same way that risk and return are positively correlated in equilibrium, impact and return will be negatively correlated—one must be sacrificed for the other.

It is a misconception to think that all investors whose investments have social impact are “impact investors.” PIIs affect the markets by addressing a need that standard market forces cannot satisfy; they effectively generate more funding for society. FLIIs meanwhile create no meaningful market impact.

What’s at Stake?

Although distinguishing impact investor types mitigates the tendency to give credit where it is not due, it also serves an educational purpose. There are many FLIIs that genuinely desire to make impact even if it is costly; they require market returns not because they are unscrupulous but because they have been told to expect them.  Consequently, the reach of their investments is falling short and preventing meaningful impact. By creating awareness regarding the return-impact tradeoff, we expect that many would modify their investment strategies. Instead of expecting market returns, a subset of FLIIs would become PIIs and search for investments that profit-motivated investors don’t find desirable.