Many investors use a strategic asset allocation (SAA) process to shape their portfolios over the long term. What place should environmental, social and governance (ESG) issues have in the SAA process?
We believe that SAA and ESG are closely linked. Environmental and social change should shape the way we allocate capital to generate long-term returns. The relationship works the other way too: SAA can direct private capital to where it’s most needed to help alleviate the most pressing social or environmental problems.
How ESG affects SAA
Let’s take the E in ESG first. Environmental issues pose increasing risks for investors. Global warming poses both long-term physical risks and nearer-term risks as the energy sector shifts from fossil fuels to low-carbon alternatives. These risks will affect the performance of certain asset classes in various ways. For example, real estate and infrastructure are at particular risk in areas prone to flooding, storms and wildfires. Physical climate risks also have implications for the insurance sector. Meanwhile, power utilities, oil and gas, transport and some industrial activities are at risk from the move away from fossil fuels.
Then there’s the S in ESG: social. Perhaps the most important challenge for SAA today is the fact that interest rates remain stubbornly low – with obvious implications for long-term returns from government bonds. Many economists argue that this is because of a chronic ‘savings glut’. Essentially, too much global savings is chasing too few investment opportunities – pushing down interest rates in the process. The savings glut has various causes, but among the most important are two social factors: aging populations and income inequality.
Corporate governance – the G in ESG – is also important for SAA. The biggest event for asset prices in the last 80 years – the global financial crisis – was largely caused by systematic failures of governance in the global banking industry. One lesson from the crisis is the need for long-term asset allocators to be more attentive to systematic governance risks.
How SAA can affect ESG
Investors typically think about asset allocation from the perspective of investment returns. But capital-allocation decisions can also make a difference to social and economic outcomes. A defining feature of many of the world’s biggest challenges is that solutions require increased flows of private capital. The most important example is climate change. To meet the goals set out in the 2015 Paris climate agreement, investors need to allocate an additional US$1.5 trillion per year to renewable energy and other low-carbon projects.
Increased capital flows are also necessary to achieve other UN Sustainable Development Goals: accelerating development in poor countries; and protecting an increasingly fragile environment (as with tackling air pollution and water scarcity). Greater capital investment is important, too, to address the relative decline of ‘left-behind’ regions within developed economies, arresting the destabilising political consequences of economic inequality.
Increasing the impact of SAA
Climate change offers a test case for improving the impact of SAA. Investors can use the equity and bond markets to allocate to companies and projects that provide low-carbon energy and transport solutions. Renewable-infrastructure equity, ‘green bonds’ and sustainable property offer additional avenues for environmental impact investing.
At Aberdeen Standard Investments, we have constructed three model portfolios with different ESG-related allocations.
At Aberdeen Standard Investments, we have constructed three model portfolios with different ESG-related allocations. These span an estimated 3% allocation to climate change in a traditional equity-bond portfolio, a more diversified portfolio with a 7% allocation and a climate-aligned portfolio with around 20% of its assets assigned to climate solutions. Our research shows that these portfolios offer very similar expected returns and risk, but with very different real-world impacts.
This raises an exciting possibility. It suggests that the SAA process can be modified to create strategic portfolios with significantly higher capital allocations to finance the energy transition, but without sacrificing expected risk-adjusted returns. By taking this approach, investors may be able to help close the climate-financing gap, without compromising investment returns or conflicting with fiduciary and regulatory constraints.
To have maximum effect, this high-impact SAA must be coordinated with more ambitious government policy and efforts to accelerate technological change and encourage investor ingenuity. It requires a shift in mindset: investors must realise they need not just passively respond to market forces, but can play a role in shaping a more prosperous and sustainable future.
Towards a more sustainable future
If investors are serious about ESG integration, they need to consider how ESG factors affect long-term investment returns. Our work suggests that these factors are among the most important drivers of long-term returns and therefore deserve to be incorporated into the SAA process. Asset-allocation analysis that integrates ESG effectively ought to deliver better risk-adjusted returns than that that does not.
But ESG-integrated SAA offers investors an even more intriguing opportunity. Many of the world’s biggest problems are a result of a failure to invest enough capital. The SAA process provides a way to begin to remedy this: for investors to channel their capital to increase its real-world impact. SAA also allows investors to do so in a disciplined way that avoids compromising expected returns.