Towards climate-aware asset allocations

Building a portfolio according to clients’ preferences

In essence, building asset allocations is akin to preparing a meal for the guests of a restaurant. Just as the chef has to juggle with guests’ culinary taste and the ingredients that are in season, so an asset allocator has to construct a portfolio according to clients’ preferences while taking account of financial, legal and market constraints. But even when the goal is set, the proof remains in the pudding. In the case of a wealth manager, this means optimising a strategic asset allocation (SAA) based on the investable assets available and taking account of their characteristics. There are valid reasons for doing so, even beyond the need to ensure this planet remains viable.

First, the economic implications of climate change will affect the returns of most, if not all, asset classes and hence, the returns investors can expect from their portfolios. Based our estimates, the impact of climate change will reduce the performance of a 60/40 portfolio by 0.1% per annum in the next 10 years. In the wake of green and sustainability-linked bonds, new asset classes are also likely to emerge in response to climate concerns and environmental, social and governance (ESG) issues in general. Such assets will need to be analysed closely by asset allocators to determine their place in a diversified portfolio.

Second, climate concerns may mean the risk landscape changes for asset classes. As the world rushes towards carbon neutrality and investors increasingly integrate ESG factors into their investment decisions, companies and entire industries unable or unwilling to adapt may find themselves abruptly cut off from access to capital. On a day-to-day level, companies could see their business dwindle as customers turn to more sustainable alternatives. In addition, even though the physical impact of climate change is mostly expected to be felt after 2030, the number of extreme weather events is already increasing, disrupting key sectors. For example, oil & gas companies are exposed to the growing number of hurricanes, while chemical industries are exposed to droughts, whether at their or their suppliers’ production sites.

Third, the way asset classes behave relative to each other could also increasingly be affected by climate issues in the years ahead. The correlation between the largest components of most classic asset allocations, equities and bonds, is closely scrutinised as it has a significant influence on overall portfolio diversification and drawdowns. Inflation is known to be the chief driver of the bond-equity correlation; higher inflation means a tighter correlation. Hence, should climate change raise inflation significantly, the diversification benefit of classic asset allocations could diminish. While we expect the overall impact of climate-change considerations on inflation to be relatively limited for the next decade, this is an additional uncertainty to keep in mind, especially at a time of disturbingly high and sticky consumer inflation prints.

We are constantly developing our understanding of the transmission channels through which climate change impacts the financial world, integrating increasingly precise sets of data into standard risk frameworks. As scenarios are adjusted for climate change and become more sophisticated and as climate stress tests become increasingly common within the financial community, we would expect SAAs to become more climate resilient over time.

Actually, reducing the carbon footprint of a portfolio or an index need not come at the expense of risk-adjusted returns, at least up to a certain point, with studies showing no decline in the risk-adjusted performance metrics of portfolios that actively try to reduce their carbon intensity as a criterion. Scientific Beta, a producer of smart factor indices, showed that applying a low carbon overlay to its suite of indices reduced their weighted average carbon intensity by about 50% without impacting metrics such as exposure to rewarded risk and risk diversification.

Major index providers have managed to produce decarbonated benchmarks without altering their financial characteristics. For example, Paris Agreement-aligned benchmarks from MSCI exhibit very similar risk-returns profiles to their regular, free float-weighted counterparts, with tracking error of no more than 2%.

All these elements seem to indicate that one can indeed significantly reduce the carbon intensity of a portfolio while maintaining (or even improving) its risk-return profile and without sacrificing diversification. This leaves ‘hotter’ stocks particularly vulnerable at a time when the pressure to manage portfolios’ carbon exposure is growing fast.