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In late 2020, the Forum for Sustainable and Responsible Investment stated that US sustainable investing assets had topped $17trn, or some 33% of all US financial assets under professional management. Unfortunately, such figures are a case of overstatement and under delivery.
Much of what is liberally classified as “sustainable investment” lacks substance. Simple screens and the token consideration of ESG factors in the investment process generate few, if any, real-world benefits for people and planet. Much of the $17trn in sustainable investing is in fact a security-level activity. That may lead to the refusal to purchase certain securities, due to involvement in a controversial activity, or a sustainable factor may increase or decrease a price target by a few percentage points. However, the solution to the predicament of overstatement and under delivery lies not in improving such single security selection – it sits squarely with asset allocation.
Asset allocation – the conscious choice of which asset classes to invest in – is said to provide upwards of 80% of a portfolio’s financial returns (the rest being instrument selection, such as stock picking). It is therefore by far the most important choice an investor can make when seeking to preserve and grow their wealth. It is also the most important choice an investor can make when seeking to generate real-world impact through their investments.
Sustainable factors often do not enter the asset allocation debate. When they do, they are typically considered at the end of the process and treated as a constraint
Sustainable factors often do not enter the asset allocation debate. When they do, they are typically considered at the end of the process and treated as a constraint. One popular approach takes the conventional two-dimensional trade-off between return and risk and adds a third dimension: sustainability. This frames sustainable investing as a concessionary activity, with the implication that greater sustainability will come at the expense of return or with an increase in risk. In this model, sustainable factors do not directly influence expected risk or return; they are instead a price to be paid.
The solution to overstatement and under delivery is dispensing with the trade-off paradigm and instead embedding sustainability in the asset-allocation process – from future asset-price forecasts, to the asset-class universe. To do so, there are three pragmatic and return maximising actions asset allocators can take.
First, environmental and social themes (such as energy transition, income inequality, diversity and inclusion) can be explicitly factored into the macro underpinnings of an asset allocation model, namely inflation, productivity and economic growth. Meanwhile, governance considerations can be viewed at a stock-market level context, not only as a single-security consideration. The importance of this is illustrated in Japan. As corporate governance there improved, the return-on-equity gap between Japanese and global stock markets has reduced from seven percentage points to four over the past decade.
Second, there are attractive fixed-income investments that asset allocators are currently underutilizing. Multilateral Development Bank (MDB) debt – such as that issued by the World Bank – is one such asset. With a correlation of 0.99 to AAA-rated government bonds, MDB debt can fully replace conventional AAA-rated sovereign exposure in an asset allocation framework. Once purchased, investors can advocate for governments to support further MDB capital increases. This will facilitate greater MDB debt issuance and lead to larger positive real-world impacts. Green bonds – where proceeds are exclusively spent on sustainable projects and services – represent another asset-allocation opportunity. With $1trn of bonds outstanding, the market is now deep and liquid enough to be the sole source for many portfolio’s investment-grade exposure. Investors can also raise their voice and advocate for additional issuance of instruments such as waste-reduction bonds, which enable a greater diversity of sectors to issue use-of-proceeds bonds.
Third, public market strategies can be complemented with a more diverse range of alternatives, rather than the asset allocator’s go-to of liquid hedge funds. Strategies in private markets can be particularly impactful as fresh capital is deployed onto corporate balance sheets to help companies grow and contribute additional impact. The private market space within an asset allocation strategy is rich with opportunities, including microcredit, renewable energy, agricultural finance, sustainable infrastructure and impact growth private equity as popularized by private equity titans TPG, KKR and Partners Group. Each asset provides valuable diversification as such exposure is hard to replicate in public markets.
While the propensity to mislabel an ever-increasing quantum of assets as sustainable appears unwavering, as investors, we have an opportunity to improve the quality of those assets and the real-world impact they deliver. Taking direction from sustainable equity investors, who, in the last decade, have successfully dispensed of the misconception that their approach entails a trade-off, asset allocators must now follow suit. By addressing the source of over 80% of portfolio returns, we can overcome our industry’s challenge of overstatement and under delivery.
James Purcell serves as Group Head of Sustainable Investment at Quintet Private Bank. He is the former Global Head of Sustainable and Impact Investments at UBS.