How LPs can overcome benchmark ‘constraints’ on impact

Financial benchmarks are the 'primary way' LPs define success but they often fail to account for externalities, said ex-KIC CIO Scott Kalb.

LPs are being hampered in their impact investment efforts by financial benchmarks that do not take externalities into account, according to former Korea Investment Corporation CIO Scott Kalb.

A “key issue that asset allocators face… are the constraints imposed by their benchmarks,” Kalb said in a keynote address at last month’s Impact Investor Global Summit. “The primary way that they [LP boards] communicate their expectations for returns and risk to the CIO and the investment team of the organization is through the setting of traditional financial benchmarks.”

Benchmarks allow allocators to analyse the performance of an asset relative to its peers and are a key part of LP decision-making. An investment team’s performance is often assessed on its ability to overdeliver according to a particular benchmark, and teams may be financially incentivised on this basis. Benchmarks are also used to communicate expectations to external asset managers, Kalb said.

Kalb worked at the Korean sovereign wealth fund from 2009-12, and held positions as CIO and deputy CEO. He is also the founder-director of the Responsible Asset Allocator Initiative (RAAI) at New America, a think tank based in Washington DC. The RAAI developed an index that rated approximately 200 sovereign wealth funds and government pension funds on their responsible investing practice, according to its website.

While benchmarks can be effective at measuring “idiosyncratic risk”, meaning the differences in an asset’s performance compared to others in the same sector or region, Kalb explained that “the problem is when it comes to externalities” and systemic risks such as climate change or negative social impact. For example, carbon emissions are not incorporated into traditional financial benchmarks, even though there is a growing regulatory trend towards carbon taxes.

The result is that impact-positive investment opportunities can underperform according to these benchmarks, deterring CIOs from investing in them. Kalb pointed to MSCI All Country World index as a benchmark that fails to take account of externalities. According to the index, in 2022, coal (+81.6 percent), and the exploration and production of oil and gas (+67.2 percent) both achieved substantially higher relative performances than education (+25.7 percent). An investment team that is being incentivised to overperform relative to the benchmark is unlikely to prioritise positive impact in this scenario.


LPs are implementing a range of measures to give impact greater weight in allocation decisions, according to Kalb. One is “widening their tracking error limits”, which define how far an LP can deviate from the benchmark and therefore how much risk they can take.

Others are changing the benchmark they use. A number of indexes are being developed that seek to include externalities and systemic risk as part of financial accounting, including the Transition Pathway Initiative. Though those developments show “a lot of promise”, Kalb noted that there are still questions to answer: “What happens to historic data? Do you have to then recalculate these externalities? Going back historically, how do you compare performance?”

A more extreme option is moving away from a benchmarking system all together, and towards an absolute return target: “One of the reasons why you see a lot of asset allocators gravitating towards using absolute return type benchmark targets is because… you can actually do more there,” Kalb said. “You’re less constrained and you can take different kinds of risk as long as you hit your overall returns.”