Incorporating climate change in asset allocation and portfolio construction

Indrani De

Portfolio construction is both a top-down and bottom-up investment process. The starting point is asset allocation, the choice of asset class mixes and their relative weights. A simple and broad definition of asset classes would be the two parts of fixed income, rates and credit, along with equities and alternatives. Alternative asset classes used by institutional investors commonly include commercial real estate, residential real estate, farmland and commodities. Commodities, in turn, fall into two broad categories: industrial and agricultural.

Some asset classes can be differentiated based on whether they are publicly traded or in private markets – eg, listed equity versus private equity, public credit versus private credit – but their fundamental underpinnings are quite similar and are differentiated mainly by the illiquidity premium of being available in private markets only. This is a broad definition of asset classes and one can keep getting more and more granular. Once the asset allocation is done, it is possible to choose active funds, index funds or individual securities to make up the percentage of total portfolio in each individual asset class. Asset allocation is