Strategic Asset Allocation is not enough, long live Strategic Risk Allocation

The words we use and the way we think interact, all the time. They influence our beliefs, our mental models, and thus our actions. In the investment industry we have our high priest memes of beta, alpha, CAPM, benchmarks and tracking error. SAA, strategic asset allocation, is part of this lexicon. It is time to realise when using this term that it may be unhelpful because of the constraints to our thinking it brings in its wake.

“SAA is not dead, but we surely need to do a bit of SRA thinking before we get to the strategic allocation of the actual assets.”

I recently attended a conference session where the topic was SAA: plugging the SDG and climate finance gap. An under-researched area, to be sure. The session’s facilitator helpfully highlighted objectives, investment strategy and SAA as key concepts for an asset owner to lead them through their high-level decision-making. Investment beliefs were not mentioned. Then the lead speaker with an energy background acknowledged they had no SAA experience, though they did mention risk. Next up, a panellist advised us to rethink SAA. Helpful. Then another speaker said they did not want to use the word risk, but promptly used it over ten times, and introduced the SDGs. Another panellist took a very social approach to risk. And one panellist only got to investment beliefs once the session was 65 minutes old. It really is time to let real world risks influence our thinking about investment strategy.

Their comments made an excellent case for retooling a piece of SAA as SRA, strategic risk allocation. SAA brings with it all the baggage of our current thinking about investment strategy. The newer big risks that SAA must deal with, like climate change, find it hard to get a look in. The SAA models can’t cope. And we know SAA is really a risk allocation exercise, anyway.My own thinking had been evolving after an event in the same week (yes, this was PRI in Person, in Paris). A speaker was extolling the virtues of the new low carbon indices which are emerging from the work on the EU Sustainable Finance Action Plan. After saying how good the indices are, they said they had some concerns about the tracking error that the indices showed versus standard market indices. What a strange view! Surely an investor chooses the new indices since they offer a better metric to capture the investor’s low carbon beliefs, their desired capital market risk exposures. In that case the tracking error that makes sense is surely that of an actual portfolio against the low carbon index, not that of a low carbon index against a standard one. I was reminded of a piece of research that a wise colleague wrote many years ago about another consulting firm’s advocacy for a multi-nationals index. The title did not endear my colleague to the other firm: Shall we bend the indices or straighten our thinking?

Can we change the way we think and talk about this? I believe we can. Strategic Risk Allocation, SRA, links the big risks lurking in the real world with strategic investment risk. As we consider how to tackle risks such as climate change, SRA gives us a new space to do some good thinking before we get to SAA. The tyranny of benchmarks and those tracking error concerns don’t encroach as much. SRA is amenable to a number of qualifying descriptions: climate-aware SRA, SDG-aware SRA, Paris-aligned SRA. Readers will think of more. SAA is not dead, but we surely need to do a bit of SRA thinking before we get to the strategic allocation of the actual assets.

When I put it to the panel what they had just crafted, in collaboration, one panellist kindly said they loved the SRA idea. Her firm advises and influences many $bns. Do others who work in this area believe the time for SRA has come?