Time to Consider a Multi-Asset Strategy?

A multi-asset approach can offer a focused exposure to the climate theme, writes Craig Mackenzie, Head of Strategic Asset Allocation at abrdn.

With China now aiming to be carbon neutral by 2060 and companies making rapid progress in alternative energy technologies, we are on the cusp of a revolution. We expect to see a massive shift in the way we live and work. Forecasts suggest 20-fold growth in revenues for electric vehicles and renewable energy by 2050. This is a fantastic long-term growth story.

There are many investment solutions that seek to capitalise on the climate opportunity. Among them, we believe a multi-asset approach is particularly compelling. Here, asset managers can offer investors a focused exposure to the climate theme, while carefully managing the risks that sometimes come with higher return potential.
Strong thematic exposure

The first challenge for investors is how to access the climate theme. It can be surprisingly hard to find investment funds with strong exposure to the technologies that will drive the low-carbon transition.

This is counterintuitive, given the dozens of sustainability funds on the market. But if you take a look at the top-10 holdings in many funds with ‘climate’ or ‘sustainable’ in the label, you will frequently find mainstream names like Microsoft or Amazon. These companies may have good operational environmental policies, but they are not strongly exposed to the climate opportunities theme. Why, then, are they in the portfolio? We suspect it is because most sustainability or climate funds have standard equity benchmarks and tight tracking-error limits that require them to hold benchmark-like exposures.

Indeed, our initial analysis suggests that standard global equity benchmarks only have a 5-10% exposure to EU Taxonomy-aligned activities. We find that many funds that are labelled ‘sustainable’ do better than this, doubling the level of exposure to 20%. However, this still leaves 80% of funds exposed to activities that are not strongly associated with the sustainability theme.
One solution is to forgo standard equity benchmarks and instead start with a list of companies whose core businesses are to provide climate solutions. This means investors can potentially align 75% of their portfolio with the EU Taxonomy, rather than a mere 20%. This, though, does mean that such a fund will perform differently to standard equity benchmarks. However, we believe that if an investor is serious about gaining strong exposure to the climate theme, then the portfolio has to look different to a benchmark that is only 5% exposed to this theme.

Managing risk

While strong thematic exposure might be an investor’s goal, there can be dangers in taking a highly concentrated exposure to sustainability themes. The S&P Clean Energy Index provides a good example. It sold-off during the pandemic shock in March 2020, then rose sharply, before falling again by 50% from its peak in January to May this year. Overall, it has offered investors decent returns – but put them through quite a roller coaster ride. By our calculations, the volatility of exchange-traded funds (ETFs) based on this index has been around double that of standard equities over the last three years. There is a similar story for other thematic ETFs.

How can we achieve a smoother investment journey? We believe diversification provides the answer. And one way is through a multi-asset approach that seeks to ensure diversification at two levels: through equities and across asset classes. Within equities, investors can have broad exposure across the full range of companies exposed to the climate theme. Investors can also diversify across asset classes. For example, by holding pure climate exposures in ‘green bonds’, renewable energy infrastructure and ‘green equities’.

To illustrate this, we created a model multi-asset climate portfolio. As the chart shows, the strategy was able retain a very high exposure to the climate solutions theme – but with less than half the volatility of the S&P Clean Energy Index.

Final thoughts…

We believe positive environmental change will come in part through the investments and the choices we make. One way is by investing in companies that are engaged in activities that seek to help the world mitigate, or adapt to, climate change. In doing so, as investors we can play our part to ensure climate change is not inevitable.

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