By Toby Belsom, Director of Investment Practices, PRI
Two weeks ago, we hosted a one-day event for PRI signatories in The Hague. One segment of this well-attended event was a small workshop on strategic asset allocation (SAA). Attended by 15 specialists in the field, the discussion focused on how issues such as climate change, demographics and resource depletion should influence and might be reflected in this process.
SAA is about forming views of the long-term returns available from different asset classes and then building portfolios with the best expected risk-adjusted returns, subject to various constraints. The long-term process aligns these decisions with ESG themes making this discussion both interesting and timely.
Yet this area has received relatively little coverage in the discussion of responsible investment. This is surprising as a broad variety of factors including ageing populations, shifting demographics, governance, climate-related risk and resource depletion can influence long-term asset returns. Recognising and incorporating these factors into the SAA framework may help and inform the process and improve outcomes.
The workshop discussion around this issue was fascinating and broad ranging. It covered concepts including the need to consider ‘hard’ and ‘soft’ returns, ‘structural breaks’ in correlations between and within asset classes, how to forecast timescales beyond the business cycles (three years), the need to refine – or at least challenge – the concept and definitions of asset classes, how we integrate ‘climate damage costs’ and how this informs asset manager selection.
Hard and soft returns
On ‘hard’ and ‘soft’ returns, the discussion focused on a similar theme to that raised in the PRI’s recent discussion paper on Embedding ESG in the SAA process. The paper, and the discussion last week, covered the possibility of extending the concept of returns so that real world impact (or soft returns) are incorporated into the development and structure of multi-asset portfolios. Work by Aberdeen Standard and the PRI questions why – if certain portfolio structures produced a similar expected risk-adjusted return with different real-world impacts – then why would the asset owner not select the asset mix with the optimum real-world impact.
Expected asset returns
Decisions around asset allocation are largely informed by historic asset class returns. However, the more pressing question in the workshop was how well these correlations will work in future environments. Environments which might throw up scenarios such as the Inevitable Policy Response – where abrupt policy change is triggered by political, social or climatic events – might produce a structural break between historic and future returns. One example discussed was the US high-yield energy sector whose performance has diverged from broader US high-yield asset class – is this the type of ‘structural break’ that asset allocators need to review?
Forecasting beyond the business cycle
Demographics, climate change and shifts in inequality all matter when forecasting long-term returns on a range of asset classes. Yet most stretch beyond a three-year business cycle and the tenure of a portfolio manager or trustee. How can SAA systematically reflect these fundamental long-term changes when any reasonable forecasting period only extends three years? Mapping different scenarios clearly provides one option, but the data issue and the long-term horizons involved meant trustees or SAA have to make some ‘bold’ assumptions to justify changes in asset allocation from the 40/40/20 mantra (equities/fixed income/alternatives).
Minimising collateral damage
In a slightly more depressing section of the discussion, we touched on how and if asset allocators now need to integrate ‘climate damage costs’ into their SAA process. Recognising that, whatever the outcome around the implementation of the Paris Agreement, climate change is on a runaway trajectory and certain asset classes have greater exposure than others. The resounding question was therefore how this could be recognised in an asset allocation process.
Selecting asset managers
Another route discussed to identify a ‘solution’ is to focus on asset manager selection, not asset allocation. Integrating ESG into the ’top down’ process – not by altering asset allocations – by selecting asset managers that systematically integrate ESG into investment decision-making process. Asset allocators felt that this process would then be reflected on all asset decisions and filter through into performance without having to base asset allocation decisions on new assumptions. But this also raised the prospect of how trustees or investment consultants can construct a list of multi-asset managers who took a broadly consistent approach to ESG so as not to ‘cancel each other out’.
In summary, it was great to be involved in a fascinating discussion among a group of asset allocators who had clearly grappled with the challenges posed by changing technology, regulation, demography and climate. We cannot claim to have found a clear way forward – and maybe there is not one clear answer. We certainly covered some issues and challenges that those involved in SAA need to start incorporating into the decision-making process.
This blog is written by PRI staff members and guest contributors. Our goal is to contribute to the broader debate around topical issues and to help showcase some of our research and other work that we undertake in support of our signatories.
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