“For example, instead of investing in oil and gas companies to hedge against an oil price spike, we might invest in bonds with commodity-linked currencies such as bonds denominated in the Norwegian krone or Australian dollar.”
Another way to integrate sustainability into capital market assumptions is through using quantitative climate scenario analysis, according to David Attwood, senior investment analyst in the strategic asset allocation research team at Abrdn.
Climate change poses long-term risks to investment returns, both as a result of damage to physical infrastructure form a changing climate and as a result of the economic shifts as the world transitions to a zero-carbon economy.
So if climate change affects risk and return, then it should be included when developing views on expected returns for asset allocation purposes.
Attwood says: "Our climate framework provides an assessment of an asset’s fair value under a range of climate scenarios (ranging from net-zero outcomes to 'hot house' worlds), from which we can understand the 'mis-pricing' when compared to current market prices.
“Through making assumptions about how quickly this mis-pricing will be corrected, prospective return forecasts for core asset classes can be adjusted.
“Improved workforce participation and corporate governance – components of the S and G pillars of ESG – can also improve corporate profitability, which is a key driver of listed equity total returns."
He adds: “The implications of sustainability factors on risk characteristics is a growing area of research, and only through improved reporting and disclosure – not to mentioned growing historical data – will we understand more [about] the inter-relationships.
"At present, we therefore prefer to express our views through return adjustments rather than risk, accepting of course that the combination therein is one of the fundamental drivers of asset allocation outcomes."
What investors prioritise will fundamentally depend on their own unique financial objectives.
But Quilter Cheviot’s Eve says investors should be looking more closely at fixed interest investments given the massive valuation changes seen over the past 18 months.
She says: “Fixed interest investments are now providing positive returns with 10-year gilt yields moving from 0.975 at the start of 2022 to 4.18 per cent by the end of May 2023.
“As such, traditionally lower risk investments are now producing attractive returns and as such should be considered as part of a fully diversified multi-asset portfolio of investments.”
