Net-zero investing and its impact on a 60-40 allocation

GLOBAL warming and the net-zero transition have far-reaching implications for investors. Embracing a net-zero path will impact investors’ asset allocation in two ways. Strategic asset allocation decisions will need to consider how the transition will impact economic and financial variables, and thereby the returns investors can expect.

Investors can embrace the net-zero path within their equity and corporate bond allocations to ensure their portfolios are net-zero aligned. In doing so, investors will have to reassess traditional asset allocation approaches, so as to reflect the fundamental shifts in the world’s economy caused by climate change.

For climate targets to be realised, the asset allocation decision can be implemented in different ways. These include using a passive climate-aligned benchmark, embracing a net-zero active cross-asset allocation, or using an active cross-asset strategy that incorporates specific targets for green investments.

Asset owners will inevitably face trade-offs when introducing climate considerations into their portfolios, the most prevalent one being a trade-off between portfolio diversification and the incorporation of climate targets.

To grasp the implications of the shift to a net-zero allocation, we compared several implementations of this against a standard, non-climate aligned asset allocation (60-40 equities to fixed income).

Why integrate net-zero targets in asset allocation

Net-zero investing goes beyond the concept of low-carbon portfolios. These portfolios must include a second dimension, the contribution pillar or, in other words, the financing of the transition to a green economy. Given this is one of the major challenges of net-zero investment policies, why then do investors still decide to integrate net-zero targets into their asset allocations?

Integrating net-zero targets into asset allocations can provide benefits from a risk-return perspective. The low-carbon transition is likely to bring about significant opportunities for investors, as new business models emerge that will probably perform better than the old models.

A net-zero economy is likely to be structurally different from the economy we know today. While it is impossible to predict whether net-zero portfolios will outperform business-as-usual portfolios, integrating net-zero considerations into investments today will allow investors to anticipate these differences, and thus be better positioned in the future carbon-neutral economy.

Furthermore, net-zero portfolios are less likely to be impacted by transition risks. These can arise at both the issuer and investor levels. Integrating net-zero targets and reducing greenhouse gas (GHG) emissions can also contribute to mitigating the physical risks arising from climate change. This reduction in physical risks will be indirect, although in the long run, the fall in GHG emissions will reduce issuers’ exposure to extreme weather events.

Beyond risk-return, integrating net-zero targets into asset allocation makes sense from an impact perspective. Long-term institutional investors should consider integrating climate considerations across all asset classes in their portfolios.

The net-zero objective encompasses different sub-objectives, which would be difficult to include in a single investment strategy. As a result, integrating net-zero considerations into the asset allocation process is a way to target several sub-objectives that contribute to reaching the net-zero goal by 2050.

Integrating net-zero targets in portfolios

Two main building blocks for net-zero portfolios are net-zero contribution portfolios and the net-zero transition portfolios.

Net-zero contribution portfolios are meant to invest in projects and corporates that develop technologies and solutions contributing to the energy transition. They usually improve the green share of an allocation by investing in climate-friendly businesses.

The objective of the net-zero transition portfolios is to gradually decarbonise investments in line with the objectives set by the Paris Agreement and ultimately reach carbon neutrality by 2050.

The main investment approaches to achieve this objective is to guide equity or credit investments in order to align corporates with a trajectory compatible with the target of limiting global warming to 1.5 degrees Celsius above pre-industrial levels, as well as divesting from issuers that do not show sufficient effort to transition.

With that said, divestment should be used as a last-resort solution with reduced portfolio emissions not simply being a result of not investing in the high polluting sectors. Institutional investors should instead, through their engagement efforts, encourage investee companies in their transition and make sure that portfolios seek carbon reductions in the real world.

The financial impact of building a net-zero portfolio

Understanding the impact of switching to a net-zero asset allocation is key for responsible investors. In comparing implementations of net-zero asset allocations against a standard, non-climate aligned asset allocation, dimensions such as their financial performance and risk, sectoral composition, and ESG (Environmental, social, and corporate governance) and climate performance (measured in terms of ESG ratings and carbon emissions) are analysed.

Unsurprisingly, integrating net-zero targets into investors’ asset allocation has an impact in the short term on key portfolio metrics. This impact materialises mainly through higher tracking errors.

However, this is expected given the fact that the economy is not yet aligned with global decarbonisation goals. These suggest that while the short-term financial cost of integrating net-zero considerations into investors’ asset allocation is limited, it should be offset over the long run as corporates gradually transition towards low-carbon models.

There was also significant improvement in the ESG and climate metrics of the net-zero asset allocations compared to the standard asset allocations. The active asset allocations showed an important reduction in carbon intensity as a notable proportion of corporates have set science-based targets.

Net-zero asset allocations also showed some degree of sectoral deviations compared to the standard allocations, with the highest deviations linked to the energy and technology sectors. These sectoral deviations anticipate structural changes and puts an investor in a better position to profit from them.

As such, although incorporating net-zero targets can be costly in the near-term, this impact should be mitigated as the economy becomes more aligned toward a 1.5 deg C trajectory in the future. In fact, embracing climate considerations can have positive results for investors over the long-term, and an active approach can enable them to overcome the risks associated with incorporating net-zero targets in their portfolios.

The writer is head of Amundi Investment Institute