For decades, Strategic Asset Allocation (SAA) has been the north star for institutional investors. It’s methodical, disciplined, and leans on historical data to craft asset class targets that are intended to optimize portfolio returns for a given level of risk. But here’s the catch: the future, especially one featuring climate change, will not look like the past. Enter the Total Portfolio Approach (TPA), a portfolio construction method which certainly seems like it could have been designed with climate risk in mind.
Let’s dig into this shift. While SAA asks us to play a long-term, rules-based game, TPA embodies a more flexible approach. The advantage? A more integrated, forward-looking framework that’s better suited to capturing risks and opportunities that cut across asset class lines. Not surprisingly, this resonates in a world where climate risks defy tidy categorization.
SAA’s Achilles’ Heel in a Changing Climate
SAA’s structure is both its selling point and its Achilles’ heel. It gives us neatly defined asset class buckets and rigid boundaries to ensure discipline. But this discipline starts to look like rigidity when you’re facing systemic risks like climate change that affect every sector, geography and asset class in interconnected ways. Here’s why:
- Rigid Allocations: Fixed asset class targets make it difficult to incorporate new climate-aligned investments, such as renewable energy infrastructure or green bonds, without disrupting the broader allocation framework. An investor might identify an attractive climate solution investment but struggle to fit it within predetermined allocation bands.
- Backward-Looking Data: SAA relies heavily on historical performance data, which often fails to capture the forward-looking, non-linear risks of climate change. Stranded assets or regulatory shifts – key elements of climate risk that can fundamentally alter market dynamics – are difficult to anticipate based solely on past performance.
- Siloed Risk Management: Climate risks cut across asset classes, but SAA typically assesses risk within isolated categories, potentially missing broader systemic impacts. For instance, physical climate risks affecting real estate investments could also impact infrastructure, insurance, and municipal bonds, but this interconnectedness may be overlooked.
While you can tweak SAA to include climate factors, these “fixes” often create governance complexity without addressing the fundamental limitations of the approach.
Why TPA Feels Like a Better Fit
The Total Portfolio Approach, in contrast, offers a more dynamic and integrated framework that more naturally aligns with the complexities of managing climate risk. Rather than treating asset classes as separate silos, TPA views the portfolio as a unified whole, in theory enabling investors to respond to evolving risks and opportunities with greater agility.
“The future, especially one featuring climate change, will not look like the past.”
- Holistic Risk Management: TPA allows for the integration of climate risks across the entire portfolio, rather than assessing them within individual asset classes. This system-wide perspective ensures that interconnected risks – such as the cascading effects of carbon pricing or the physical risks of climate change, are considered without regard to asset class ranges.
- Dynamic Adjustments: In a world where climate policies, technologies, and market conditions are changing rapidly, TPA provides the flexibility to pivot. For example, as emerging technologies become more cost-competitive, TPA enables investors to shift allocations toward these opportunities without being constrained by fixed targets.
- Emphasis on Alternatives: Climate-aligned investments often fall outside traditional asset classes, such as private equity, infrastructure, or real assets. TPA encourages the inclusion of these alternatives, which are critical to financing the transition to a low-carbon economy.
- Forward-Looking Risk Assessment: TPA facilitates the use of scenario analysis and forward-looking data to evaluate how climate change might impact portfolio performance. This proactive approach is essential for understanding long-term second order climate risks.
A Growing (But Quiet) Movement
Is TPA the heir apparent to SAA? Maybe, but it’s a slow burn. For now, it’s catching on with early adopters like sovereign wealth funds, large pensions, and university endowments. Harvard’s endowment, CalPERS, and others are experimenting with variations of this integrated thinking.
It might be tempting to declare TPA as a solution to the challenges in integrating climate into asset allocation. But TPA isn’t a climate strategy – it’s a framework. It doesn’t solve the puzzle of how to price unquantifiable risks or perfectly align portfolios with net-zero goals. What it might do is create breathing room for asset owners to more easily develop action plans that integrate climate considerations into their investment processes.
And maybe that’s enough.
Chris Ito
CEO
FFI Holdings