Strategic asset allocation and responsible investment
In September 2017, the Research Commission of the French Sustainable Investment Forum (SIF) launched a working group on the management of a strategic asset allocation and the related subject of asset and liability management in the context of responsible investment, coordinated by CDC and Edmond de Rothschild Asset Management, along with a number of institutional investors and asset managers, including La Française Group.
The aim of the working group was to consider the possibility of integrating the two analysis frameworks by identifying the stages in the asset allocation process in which ESG criteria may be applied. Initial findings on the state of play, data sources and investor expectations were revealed in 2018 and early 2019, and the final results will be presented at the PRI
in Person conference in September.
The general framework of responsible investment is based on integrating environmental, social and governance (ESG) criteria applied to the issuers of financial instruments into the investment process, while the strategic asset allocation is a technique for maximising risk-adjusted portfolio returns by seeking diversification benefits related to the past or projected performance of each asset. How can these two approaches be reconciled? A “responsible” asset allocation can be created in two stages, by firstly incorporating ESG criteria into the investment process adopted for each asset class (equities, bonds, real estate, private equity, hedge funds, etc.) in order to obtain “responsible” exposures, and then combining these exposures using traditional financial optimisation techniques that target the efficient frontier. This implicitly assumes that there is no diversification benefit between asset classes related to ESG criteria, and that only the financial criteria are a source of diversification benefits.
Current finance research gets round the problem by quantifying the impact of ESG criteria in terms of projected financial performance to the extent that is possible, so as to bring the analysis framework within the traditional scope of finance theory. This underlies the “Climate Value at Risk” approach proposed by Carbon Delta and supported by a steering committee on the Task Force on Climate-related Financial Disclosures in which UNEP FI and La Française Group are participants, as well as that of the Impact Management Project, a community of investors and supranational bodies, in establishing an “impact” efficient frontier which factors the optimisation of ESG scores into the construction of a portfolio.
Regulation is also relevant in that the asset allocations of European institutional investors are subject to capital backing requirements under Solvency II. This regulation only takes into account the financial risks in calibrating capital requirements and has no regard to the risks related to ESG criteria. The incorporation of a “green supporting factor” within the regulation is sometimes mentioned, but this can be somewhat more arbitrary, and the financial quantification of ESG criteria in this regard adds an operational solution.
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