Environmental, social and governance (ESG) factors can affect each security in specific ways, by increasing risks or creating opportunities. Most of these factors are part of broad trends currently affecting the economy. These ESG megatrends can have consequences for institutional investors at a strategic asset allocation (SAA) level. In a series of papers, we identify a global, ESG macro trends, which we call megatrends, and investigate how they could affect strategic asset allocation decisions and portfolio risk-return profiles.
ESG and the economy
As we've witnessed in the first half of 2020, structural economic changes and macro-level events have roots in ESG factors. From pandemics and environmental degradation to social unrest, ESG issues have shown their potential impact on the global economic situation. While it is increasingly common to factor such ESG concerns into the security selection process, ESG integration within a strategic asset allocation framework seems less prevalent.
We believe awareness of ESG megatrends may enhance institutional investors' decision making. Understanding long-term, global systemic risks can help inform investment decision-making today to help mitigate risks in the future. In this series, we explain the role of ESG integration in the strategic asset allocation process. Our views are based on recent studies identifying ESG trends that are expected to shape society for the next decades. We identify 16 ESG megatrends within six key categories.
Source: Aegon Asset Management, April 2020.
Not all megatrends may be directly relevant for investors' portfolios or for the economic indicators that shape it. To focus our research efforts on the trends that are likely to be most material, we use a score-based framework to estimate a trend's potential direct effect on certain asset classes or macroeconomic variables, its timeframe as well as the potential intensity of its effects and probability of occurrence. We assign scores on each of these dimensions based on existing research from academia and practitioners. This leads us to conclude that five ESG megatrends are most material to the world economy, and therefore, more likely to affect investors' portfolios:
- Extreme weather events arising from the physical effects of climate change
- Risks and opportunities linked to the transition to a net-zero carbon economy
- Changes in the labor market due to increasing automation and artificial intelligence
- Demographic trends and the impact of population aging on labor markets and interest rates
- The increased risk of pandemics
Integrating ESG megatrends within SAA
For example, demographic trends will likely put a strain on public finance, tighten job markets and put downward pressure on interest rates. Meanwhile, transition risks arise from the actions taken to mitigate climate change which could potentially lead to higher prices for emitting greenhouse gases. These sorts of trends could have various financial consequences. This, in turn, may affect risks and returns across many asset classes. As a result, we believe integrating ESG megatrends when setting SAA could improve the resilience of portfolios.
To translate the trends into our strategic asset allocation, we use scenario analysis. Scenario analysis can help us to quantify the potential impact of ESG megatrends on the portfolio of institutional investors. This also enables us to test the consequences of adjusting on the probability of meeting the investor's objectives and goals as ESG megatrends evolve. We begin by uncovering the driving forces behind these trends and the implications for macroeconomic variables. This generates asset class return assumptions for different scenarios. We can then use these to test whether a portfolio is prepared to withstand those effects, and how to best adapt it to the changing world economy.