Can Investments Drive a Sustainable Future?
Here is a framework that can help institutional investors incorporate sustainability into their strategic asset allocation decisions by using integrated SAA.
By embedding key transitions – such as those in energy and food systems – into macroeconomic expectations, the framework enables investors to consider transition-related risks and align their portfolios with the overarching goal of fostering a sustainable economy. It emphasizes the transformational impact of emerging industries and the decline of outdated models. The framework equips investors so they can assess the risk, return, and impact of their investments on stakeholders, society, and the environment.
What is new about this framework is that investment impacts are endogenous; investor choices can either accelerate or slow sustainability transitions in the economy and are a direct influence on systemic risks.
Four steps to transform your investment strategy
Aligning your investment strategy with your financial and sustainability objectives entails four key steps. We have outlined them here, and you can read more about it in our full white paper on our webpages. These steps show the integrated SAA framework differs from conventional approaches:
- Set an integrated investment policy: Investors must acknowledge the interdependence of financial returns and social and environmental impact. The investors position themselves on their sustainability objectives by adopting an integrated investment policy, investment beliefs, and appetite for risk.
- Form macro-economic expectations: This step involves integrating ongoing transitions into macro-economic expectations. This shifts the focus from traditional SAA – which primarily considers risk and return – to an integrated SAA that includes systemic changes in the analysis.
- Form risk-return-impact expectations: In setting risk-return expectations on asset classes, the investors integrate a third criterion for impact alignment. Impact alignment is a stringent measurement of social and environmental impact for which actual impacts are compared against a system threshold, and by which environmental thresholds and social norms are adhered to. Integrated SAA thus allows investors to evaluate investments based on risk, return, and impact collectively.
- Construct the portfolio: In the construction of the portfolio, integrated SAA provides a balance between financial metrics and impact alignment. This approach incorporates transition factors requiring sector-specific insights, optimising for risk-return-impact to ensure portfolios effectively support sustainability transitions.
This framework offers a comprehensive strategy for institutional investors to manage their portfolios and achieves the key objective of achieving financial return and impact while managing risks.
A look at future research
This concept of impact alignment paves the way for future research by elevating it to become an integral part of the integrated investment objective. The white paper highlights some propositions for empirical research. Our first proposition relates to managing the impact alignment of investments, which can improve the whole impact alignment profile of an investment portfolio. This shifts the focus from merely proving impact to actively improving it.
We can also investigate forming expectations for risk-return-impact. For risk, we propose that companies with negative impact alignment are more vulnerable to transition risk – this is proposition 2a in our white paper. Transition risks arising from unforeseen changes may lead to lower-than-expected risk-adjusted returns; this is our proposition 2b.
These propositions spotlight the exposure to high risk of portfolios that overlook negative impact alignment; they lack the ability to anticipate and adapt to transformational shifts. In these cases, it is relevant to adopt sector-level perspectives to better understand the transition risk associated with each sector.
On the return side, our core argument centres on long-term value creation for companies with positive impact alignment. You can read more about this in proposition 3a. However, if investors fail to recognise this long-term value, it will not affect the company’s market value, as we explain in proposition 3b. A company whose business model aligns with these transitions is likely to improve its market position, adapt its cost structure, and strengthen relationships with customers and stakeholders. Yet, these benefits must be reflected in higher valuations, contingent on investors recognising the company's efforts to achieve positive impact alignment.
To test these propositions, we introduce a factor model to estimate the expected excess return as a function of the market risk premium, size, value, momentum, and impact alignment. Incorporating the impact alignment factor into this model allows for the testing of our propositions 2 and 3, and their effects on expected returns.
A tool for transition
In summary, our white paper presents an integrated strategic asset allocation framework that incorporates environmental and societal challenges. By extending their investment perspectives to include transitions into their macroeconomic expectations, investors may be able to reduce systemic risks. Understanding these transitions helps investors identify how their investments are positioned in relation to systemic thresholds. Therefore, the integrated SAA framework represents a comprehensive understanding of systemic risks and their impact on portfolios, which is valuable not only for improving the risk-return profile but also for evaluating and directing investments toward a sustainable economy.