Stockholm (NordSIP) – For most professional asset managers, integrating climate-related considerations into the investment process is a purely bottom-up exercise. Equity and, increasingly, even bond analysts know by now not to disregard any sustainability aspects when forecasting a stock’s expected return or assigning ratings to an issuer. Academic research, meanwhile, clearly indicates that when it comes to long-term performance, it is not stock- or bond-picking that investors should be paying most attention to but the strategic asset allocation (SAA) of their portfolio. Yet, many still fail to recognise climate risk exposure at the SAA level and miss the potential to enhance their risk-adjusted returns by considering the different impact that climate change tends to have across asset classes.
A new research paper by French asset manager La Française, Climate Aware Strategic Asset Allocation, seeks to address this issue and provide a framework for integrating climate-related considerations into SAA. Co-authors Pierre Schoeffler (pictured), Guillaume Diette, Benjamin Jacot, and Ludovic Thulliez argue that traditional SAA approaches are backwards-looking and therefore not suitable to assess long-term climate-related risks properly. The authors suggest using scenario-based methodologies instead to set up plausible hypotheses for the future without attributing a probability of occurrence to each of them. According to the paper, SAA “must take into account the transition of economies to a decarbonized economy, the only scenario capable of avoiding devastating global warming, by positioning itself on investments that generate performance and lower risk.” However, the authors point out that other, less optimistic scenarios need to be considered too.
The paper goes into some detail explaining how climate-related considerations can be integrated into each of the three main elements of SAA: expected returns derived from a consistent economic scenario, risk measures (volatility and correlations), and the algorithm for optimizing risk-adjusted returns.
As a starting point, the authors use the five widely recognized Shared Socioeconomic Pathways (SSP), narrative scenarios designed by an international team of climate scientists to explore alternative future developments for demographics, economics, and climate change. These same SSPs will help produce the IPCC 6th Assessment Report on climate change. They range from a virtuous scenario corresponding to compliance with the United Nations Sustainable Development Goals in the context of enhanced international cooperation to an extreme scenario of regional rivalries and abandoning any ambition in the field of climate.
The paper then proceeds to examine what would be an optimal allocation for each of the five scenarios. To do so, the researchers have developed an advanced Integrated Assessment Model featuring financial and monetary modules. The period covered runs to 2100 in five-year time steps, and both physical climate risks and transition risks are modelled. The universe of assets considered in the study covers the main financial assets: government bonds, corporate bonds (investment grade and high yield), equities, real estate (residential and office), and gold. A factor model is used to deduce each asset’s long-term expected returns and risks from the fundamental economic and monetary factors. Finally, the researchers apply a robust optimization algorithm based on a min-max regret approach, including a simulation of financial crises.
The study results provide some clarity as to what long-term SAA is optimal for each baseline scenario. One interesting conclusion is that the optimal portfolio for the fifth scenario (Conventional fossil-fuelled development) appears close to the current portfolio of the French institutional investor on average.
The authors admit humbly that the suggested framework is far from perfect and has some clear limitations. “No matter how reckless the approach, the intent is to help institutional investors cope with climate change in their strategic allocation exercise and to build a climate aware strategic asset allocation,” they assert.
This study from La Française spotlights an essential and often neglected aspect of sustainable investing. Hopefully, more responsible asset owners and asset managers will start paying attention to integrating ESG into their top-down investment decisions alongside the work done by bottom-up analysts.