Transmission mechanisms hold the key to adapting asset allocation models to dual materiality, contends Joseph Naayem, Managing Partner, Kalmus Capital.

In the good old days of single materiality, investors could afford to incrementally take a linear approach to how they integrated sustainability into their decision-making processes. As we enter an age of double materiality, allocators all along the investment value chain may find themselves having to go back to first principles and rethink their entire approaches to asset allocation, portfolio construction, fund and security selection and engagement.

If we separate the definition of sustainable investing into ESG integration, or ‘outside-in’, where the focus is on how the outside world affects financial risks and opportunities, versus impact investing, or ‘inside-out’, where the main focus is on how economic activity affects the outside world, we can single out an important parameter that had never held much importance in allocation models: transmission mechanisms.

The art of investing is based on how we allocate risk and accordingly deploy the appropriate resources to oversee it. In the old world of single materiality, relative size was everything: the larger the exposure, the greater the capital at risk, the greater the importance, the more resources, time, fees, effort and sophistication it deserved. It is little wonder that the maturity of sustainable finance, mirroring typical allocation models, started with listed equites, then fixed income before percolating through private markets and finally touching hedge funds last. This assumption – that size equals importance – has underpinned every capital allocation model to date.

Differing transition mechanisms

As impact takes on more importance in a dual materiality world, size is no longer the overriding determinant of importance, be it assets under management, relative portfolio weight, value at risk exposure or revenue line. Each asset class, investment strategy or fund structure has a different transmission mechanism that traces the causality of how capital can influence outcomes rather than just be aligned to them. This causality extends beyond the basic difference between primary investments and secondary market transactions. The level of ownership, levers of influence, credibility and knowledge when engaging on specific topics as well as level of concentration and holding period all play a pivotal role in enabling fund managers to shape outcomes on the ground.

Regulations such as Europe’s Corporate Sustainability Reporting Directive are laying the foundations for how dual materiality is measured and reported, but like many other disclosure-related regulations