How a multi-asset spectrum can support LGPS sustainable investing

Over the last decade, many Local Government Pension Scheme (LGPS) funds have made significant strides in their aim of putting their portfolios on a more sustainable footing. In many cases, this process has involved consecutive portfolio decisions that may be challenging to dovetail. We believe that one way of addressing this challenge is to adopt a multi-asset approach that combines a focus on achieving competitive returns with sustainability goals. Here, we explore how this more holistic approach can work in practice and outline how it may help LGPS funds amplify the impact of their UK-based investments.

The value of a multi-asset approach

We believe that the primary purpose of sustainable investing is to generate, alongside competitive financial returns, a tangible, positive impact in the real world. 

Investors can follow different avenues in pursuit of that dual goal (Figure 1):

• One way is to target companies that can make a difference by offering products and services that contribute to societal well-being, such as those in the health care or education sectors.
• Another approach is to focus on a company’s operational improvements, such as increasing the use of renewable energy or decreasing water usage in its operations.

In our view, each type of outcome is valid but distinct and can be achieved through different investment approaches, ranging from ESG integration to dedicated impact investing. Within each approach, engagement offers an additional dimension to drive further financial value and measurable, sustainable progress by encouraging companies to be good stewards that are exemplary in the way they balance the needs of people, planet and profit.

Figure 1

In our opinion, a multi-asset investment approach can enable investors to capture the full spectrum of these opportunities while improving diversification through different market phases. A holistic approach to sustainable investing across public and private markets also limits the risk of investment allocation decisions taking place in silos, which could result in suboptimal outcomes. Figure 2 illustrates this in the context of the energy transition. Investors can target companies offering climate solutions throughout their life cycle across public and private markets but complement that with exposures to established leaders that actively seek to reduce their operational Scope 1, 2 and 3 emissions, thus amplifying the potential for real-world impact.

Figure 2

Key features of a best-practice solution 

We believe a best-practice multi-asset framework should have the following features:

• An enhanced risk/return trade-off and sustainability potential relative to what can be achieved through single strategies.
• Inherent flexibility in order to accommodate different priorities and evolve over time. At Wellington, for instance, we have a toolkit of sustainable funds spanning impact and stewardship investments that we actively put to work within a multi-asset framework based on our view of both near- and long-term opportunities.
• Strategic asset allocation (SAA) that explicitly incorporates climate and, where appropriate, other sustainability considerations. We view SAA as the long-term, baseline allocation of a portfolio, based on long-term expectations of return, risk and correlation across asset classes, with climate change as an essential input. By way of example, in our sustainable investing multi-asset portfolios, we look to integrate climate considerations through proprietary models and research collaborations that seek to assess the physical and transition risks of climate change and their implications for different regions and asset classes. The long-term expectations resulting from this research process serve as an anchor for our asset allocation process.
• Diversification across a variety of dimensions in the sustainability space. We think it is possible to segment exposure based on the role played by these investments. Taking climate change as an example again, some investment approaches seek to decarbonise assets, while others may focus on mitigation solutions or, alternatively, target the growing climate resilience segment.  

Moreover, while the bulk of the climate investing universe has historically centred on public markets, private asset approaches have grown meaningfully in size and maturity. We think private equity can be an effective way to tap into innovation, whether at an early stage to gain exposure to new science-based solutions that have yet to scale — for instance, direct air carbon capture — or, at a later stage, with more proven technologies such as greener transport and technology-enabled agricultural solutions. It can also provide an opportunity to invest throughout the life cycle of impact-focused companies, from private markets through to IPO. 

Finally, asset owners can also consider the factor footprint of their climate exposure and opportunities to balance it directly, through portfolio construction, or indirectly, through allocations across the climate opportunity set. Figure 3 shows how diversification can help to mitigate the inherent growth bias of many climate strategies, especially those that are passively managed. We illustrate this using the Barra Factor Exposure Analysis Model, which compares a hypothetical diversified, active portfolio with passive exposure to relevant Paris-aligned benchmarks. Benchmark with respect to key fundamental stock characteristics. Here, we look at value (specifically, looking at companies’ relative earnings yields) and growth (companies’ sales or earnings growth prospects). The exposures (“values”) are standardised using z-scores so that the numbers can be compared across different managers/strategies, predominant sector/region tilts and market-cap profiles.

Figure 3

The importance of measurement 

When it comes to sustainability, the quality of measurement is crucial. Although strategies may target different opportunity sets, there should be a unified approach to measuring real-world impact, grounded in the following principles: 

• Intentionality — In our opinion, strategies should explicitly set out the positive social and/or environmental outcomes they are seeking to achieve alongside market-competitive financial returns. These goals can combine quantitative and qualitative elements, but, where feasible, they should be crystallised into key performance indicators that can be measured over time.
• Holistic approach — We also think it is critical to assess the holistic impact of a company or issuer, including any risks, to help ensure that investment decisions are made in ways that seek to mitigate negative externalities and maximise positive return and sustainability effects.
• A focus on contribution rather than attribution — Because social and environmental impacts are typically the result of complex factors, we find that directly attributing these impacts to investment decisions with a high degree of certainty is often impossible. We believe a more realistic assessment of impact focuses on the real-world contribution a given strategy can make.

Importance of engagement 

We consider engagement — discussions between investors and companies on sustainability issues — to be an essential tool for driving positive real-world outcomes across the entire sustainability spectrum, and, in doing so, enhancing long-term return potential. For example, we partner and engage with the companies and issuers in which we invest in our multi-asset impact portfolios. We believe this engagement can help create lasting value for our clients while enhancing the positive impact of our investments. In our opinion, engagement is also a tool for investors to deepen the fundamental analysis of potential investments and assess the viability of their sustainability theses.

In our view, a multi-asset approach offers scope for enhancing the depth of engagement. For instance, conversations can encompass both an equity and fixed income perspective and leverage insights gained in other areas of the portfolio, notably across both public and private impact investing.

Putting it into practice: a hypothetical case study 

For our case study, we show the results of a hypothetical multi-asset solution based on six strategies managed by different Wellington investment teams, which we believe are representative of the wider universe with climate-change mitigation and adaptation as a common theme (Figure 4). The solution encompasses broader sustainable and impact strategies and is complemented by a 10% allocation to private markets.¹

Figure 4

While evidently our portfolio is not indicative of future results, we believe the below potential features stand out:

• Appealing risk/return outcome — As outlined in Figure 5, our hypothetical portfolio delivers better performance with lower risk compared to its benchmark.

Figure 5

• Improved ESG scores — Another conclusion we can draw is that the hypothetical portfolio can deliver attractive ESG scores even with a portion (25%) of assets held being non-rated. The scores are based on Wellington's proprietary, bottom-up ESG scoring system. Calculated by a team of dedicated ESG research analysts, they evaluate how effectively a company addresses financially material environmental, social and governance risks and opportunities, with the company given a score between one and five (a score of one being the highest). A favourable distribution of scores, with 98% of rated companies scoring between one and three in their ESG scores for the multi-asset sustainable solution signifies that the companies are performing well in these areas.
• Significantly lower carbon intensity — Finally focusing on the measurable impact of our hypothetical multi-asset solution, we find that it yields significantly better outcome in relation to climate-change mitigation. Specifically, as of 31 December 2023, we estimate that the weighted average carbon intensity (WACI) of our hypothetical multi-asset sustainable solution is significantly below that of its benchmark (Figure 6).

Figure 6

Potential role in meeting LGPS funds’ broader commitments

Successive UK governments have expressed the desire to increase the role of LGPS funds in supporting the growth of the UK economy, with the creation of pooling arrangements as a first concrete step. More recently, under the so-called Mansion House reforms, former Chancellor Jeremy Hunt sought both to accelerate the pace of pooling and set mandatory targets for private equity investments in support of the last administration’s levelling-up agenda. Following the election, Chancellor Rachel Reeves announced a landmark pension review as part of the new government’s mission to “boost growth and make every part of Britain better off”. A key part of this review involves “unlocking the investment potential of the £360 billion Local Government Pension Scheme, which manages the savings of those working to deliver our vital local services, as well as how to tackle the £2 billion that is being spent on fees”.²

While it is too early to assess the likely outcomes of that review, we believe that the adoption of a sustainable multi-asset investment framework can help prepare LGPS funds for potential legislative change by ensuring a more cohesive approach to UK-based investments that supports government policy priorities. The two examples below illustrate the amplifying effect of a multi-asset framework in the context of the UK’s net-zero policies.

• Improving the energy efficiency of UK homes Poor energy management practices are a significant driver of greenhouse gas (GHG) emissions, with UK homes being laggards relative to other European countries when it comes to energy efficiency.³ High levels of domestic energy wastage also contribute to the cost-of-living crisis. In our view, addressing this challenge creates potentially attractive investment opportunities that closely align with UK policy priorities. One such opportunity that we have identified in the impact segment of our hypothetical portfolio is a leading smart meter company that operates globally and also contributed to the national roll-out of smart meters, which the UK government considers to be an essential tool in meeting its energy policy goals.⁴
• We assess the real-world impact of this investment through tracking the GHG emissions avoided by the company’s smart metering base as illustrated in Figure 7. In addition, we believe the implied energy savings can have a significant positive social impact through lower energy costs.

Figure 7

• Moving towards sustainable agriculture is another avenue targeted by policymakers to help reduce the UK’s carbon emissions in line with its binding net-zero targets. Putting agricultural production on a more resilient and sustainable footing also contributes to several of the other goals in the UK’s Environmental Improvement Plan.5 In the stewardship segment of the hypothetical portfolio, we have identified an attractive investment opportunity with a leading farming equipment manufacturer that we consider to be at the forefront of sustainable agriculture. Its innovations improve crop yields while reducing the carbon intensity of farming through more accurate spraying technology, and increased use of software and AI for agricultural planning. We believe the quality of the company’s products combined with its innovation and scale give it a clear competitive edge that will not only have the potential to drive profitable growth but also help reduce the carbon and environmental footprint of farming in the UK and beyond. As shown in Figure 8, we monitor the company’s progress through a key performance indicator of sustainably engaged acres, meaning the number of acres where two or more of the company’s sustainable technology solutions or sustainable practices have been used in a 12-month period.

Figure 8

Important disclosures

The proposed custom portfolio presented is for due diligence purposes and is not for redistribution without the express written consent of Wellington Management. The proposed portfolio’s hypothetical performance statistics are based on the actual performance of the underlying funds. The hypothetical portfolio is weighted based on the proposed allocations of 30% Wellington Global Stewards Fund, 5% Wellington Global Impact Fund, 30% Wellington Global Impact Bond Fund, 20% Wellington Climate Strategy Fund, 5% Wellington Climate Resilience Fund and 10% Wellington Climate Innovation Fund proxied by NZAC US Equity. This SPDR MSCI ACWI Climate Paris Aligned ETF is an exchange-traded fund incorporated in the USA. The Fund seeks to provide investment results that correspond generally to the price and yield performance of the MSCI ACWI Climate Paris Aligned Index. The allocation percentages of the portfolio were rebalanced monthly to maintain the original allocation percentages. This rebalancing does not consider the liquidity provisions of the underlying funds, which may not allow for such frequent redemptions. The proposed allocations are subject to change and may differ from the live portfolio.

The inception date of 2 January 2021 is used as the start date because it is the longest available time period that includes all of the proposed underlying strategies.

The proposed portfolios and the resulting performance history are hypothetical and no such portfolio currently exists. Hypothetical results have inherent limitations, including the benefit of hindsight (i.e., the performance of the proposed

allocations is already known and hypothetical results invariably show positive rates of return). No representation is being made that the proposed portfolio will, or is likely to, achieve results similar to those shown. Past performance is not necessarily indicative of future results and there can be no assurance the proposed portfolio will achieve its objectives or avoid significant losses.

The hypothetical performance record does not include the potential effects of active asset allocation because the allocation of underlying funds may change from time to time and these adjustments are not reflected in the hypothetical results. Additionally, this does not reflect allocation decisions made under actual market conditions and therefore cannot completely account for the impact of risk in actual trading. As such, none of the hypothetical performance should be considered to be an indication of the future performance of the proposed portfolio. There are often differences between the hypothetical performance results and actual results of a live portfolio. In addition, no hypothetical record can completely account for the impact of financial risk in actual trading. For example, the ability to withstand losses or adhere to a particular trading programme in spite of trading losses are material points which can also adversely affect actual trading results. There are numerous other factors related to the markets in general or to the implementation of any specific strategy which cannot be fully accounted for in the preparation of hypothetical performance results and all of which can adversely affect actual results. Investment

guidelines or restrictions that may be imposed by a client may impact the performance of the investment approach. The impact of such investment guidelines and restrictions is not reflected. A GIPS composite report is not available since the firm does not currently manage the specific blended strategy. All performance data is shown net of returns for the underlying funds or their proxies.

¹This allocation is managed separately. Risk and return characteristics are modelled using a liquid ETF proxy. | ²“Chancellor vows ‘big bang on growth’ to boost investment and savings”, UK HM Treasury, UK Department for Work and Pensions, UK Ministry of Housing, Communities and Local Government, Press release published on 20 July 2024. | ³Simon Levey, Jez Fredenburgh and Caroline Brogan, “UK behind European countries on home upgrades to combat bills and climate crisis”, Imperial College, 14 December 2022. | ⁴https://www.gov.uk/government/publications/energy-security-bill-factsheets/energy-security-bill-factsheet-smart-metering | ⁵“Environmental Improvement Plan: annual progress report 2023 to 2024”, UK Department for Environment, Food & Rural Affairs, 30 July 2024.