Alex Funk, chief investment officer at Schroder Investment Solutions remarks that climate change requires allocation tweaks to meet long-term goals.
‘It’s important to remain focused on long-term outcomes, but that doesn’t mean that we shouldn’t be making minor adjustments along the way to fine-tune portfolios.
One of the most important drivers for achieving investment objectives is strategic asset allocation. In a world where the only constant is change, it is important to assess your methodology to account for changes.
One of the most prevalent changes we as investors are facing is the impact of climate change. Climate change, whether partially mitigated or not, will affect your expected returns from various asset classes. We have three steps in assessing the impact.
The first step is a focus on what happens to output as temperatures rise, which we refer to as the ‘physical cost’ of climate change. The second considers the economic impact of steps taken to mitigate those temperature increases or the ‘transition cost’. This is more complicated as there is a range of possible transition scenarios. Finally, we adjust for the effects of stranded assets. This is where we take account of the losses incurred where oil and other carbon-based forms of energy must be written off.
One of the biggest drivers on future expected returns is the effect of climate change on productivity. Based on our analysis, we expect it will negatively affect the productivity of emerging markets more than developed markets. Considering such factors will be important in making these minor adjustments to long-term asset class return expectations, which will ultimately affect investment outcomes.
We have assessed our long-term strategic asset allocation in line with the above analysis to make minor adjustments to our portfolios. Our mid-risk portfolio reflects the following changes to our strategic asset allocation: a reduction in UK equities of approximately 2.2% to partially fund an increase in Japanese equities of approximately 2.8%, with the balance being funded from a decrease in Emerging market equities of approximately 0.6%. We have decreased our exposure to UK gilts by approximately 1% and added approximately 0.8% to our global government bond exposure. We have used the balance alongside a reduction in cash to fund an approximate 1% increase in global corporate bonds.
Some of the more notable adjustments to our long-term expected returns is a decrease in return expectations in emerging market equities and UK gilts with increased return expectation in most Developed market equities, with Japanese equities being the most notable. This, alongside better-than-expected returns from corporate bonds compared with government bonds, has informed our adjustments.
By structuring our long-term strategic asset allocation with a rolling return focus and making minor adjustments along the way, our portfolios are aligned with client investment outcomes while protecting existing investors and accommodating new ones.’