ESG investing in the long/short domain is a complex issue, one which has seen some progress but where there are still plenty of challenges and considerations, say Toby Goodworth and Chris Stevens, CFA.
The undeniable impacts of climate change, evidenced recently by severe wildfires and record-breaking sea temperatures, continue to draw investors' attention to the climate transition. This subject is both an investment theme and a matter of policy for many investors, such as the growing cohort of pension funds and other ‘asset owners’ with explicit ‘Net Zero’ targets. Implementation efforts have typically prioritised equities and fixed income, as the bulk of portfolio assets, but focus is now shifting towards alternative investments, including hedge funds or 'liquid alternatives'. Is the hedge fund sector poised to confront the dual challenge of investors' evolving priorities and the impact of climate change on capital markets?
In the vast realm of hedge funds, equity long/short funds—the single largest strategy type—appear more advanced than their counterparts on both ESG (Environmental, Social and Governance) and carbon emissions. ESG investing has its roots firmly planted in the traditional long-only equity world and, consequently, the data and analytical methods crafted for equity investing can largely be transported directly into the equity long/short domain.
Challenges and Complexities
However, there are notable complexities. Debates have repeatedly arisen regarding the use of short positions by ‘sustainable’ or ‘ESG’ investors, and these debates are now being recycled with respect to the climate or carbon subjects. To what extent does shorting generate actual influence in the real world, such as escalating a firm’s capital cost or pressuring its management? The debate also extends to the method of accounting for these short positions when quantifying portfolio metrics such as carbon intensity. Can a short position in a high carbon emitter represent a reduction in portfolio-level carbon intensity when it does not by itself reduce or prevent emissions?
Aside from these philosophical debates, hedge fund managers are facing increased demands from investors on the reporting aspects related to carbon and climate. Especially for smaller managers, there might be resistance towards the expenses associated with purchasing the relevant data from external sources and allocating extra resources to address the diverse requirements of investors.
The broader hedge fund landscape is witnessing changes too. An increasing number of managers beyond the equity world are integrating the climate transition theme, either through a consideration of climate-related risks / opportunities or through the use of new green securities like green bonds, ESG equity futures or carbon markets. Credit funds, macro funds (those that consider broader asset classes or sectors), and multi-strategy funds (an amalgamation) have all made steps in this direction. Here however there is certainly more of a focus on integrating climate considerations alongside established processes, rather than launching dedicated strategies based on the theme.
The Case for Climate-Focused Global Macro
We are particularly keen to see the launch of additional global macro hedge funds with a specific focus on climate. To date, only a handful of these exist, yet the number is rising and we are anticipating the emergence of more strategies in this group. We would strongly encourage established global macro managers to consider their approach to the subject. Historically, thematic hedge funds have had a somewhat problematic reputation: many have been sector-specific and they have often been viewed as ‘gimmicky’ or simply too niche to attract long-term investors with strategic allocations. Yet we do not believe the same limitations are likely to be true for strategies focused on the climate transition as a whole. A theme which can be expected to last decades, and impact almost all market sectors, is inherently more credible as a basis for an institutional-quality strategy.
The thematic global macro funds that have already emerged in this space vary in substance: they may look for opportunities across the energy space (generation, storage, et cetera) and also invest long or short in other sectors such as real estate, insurance and industrials — all of which will be impacted by the transition, with companies advantaged or disadvantaged based on how they are equipped to adapt. That being said, with the ever-present risk of green-washing, investors should be wary of ‘re-badged’ energy or materials-focused sector funds which have seen an opportunity to pivot to a hot area in order to attract capital.
Beyond these pre-existing strategy types, one genuinely novel area in recent years is the emergence of carbon trading hedge funds. As regulatory frameworks introduce Emissions Trading Systems globally and the liquidity of these markets improves, funds have been started to offer investors access to returns directly linked to the carbon price - either through long exposure to prices that are highly likely to increase over time or to alpha opportunities presented by these fragmented and nascent markets. For investors yearning for tangible impacts from their alternative strategies, these approaches present promising prospects. Multi-strategy and managed futures/CTA managers have also begun to provide exposure to these markets, albeit they've integrated it only as a minor portion of their portfolios.
A number of challenges are present for hedge fund investors tilting towards the climate issue. A common practice for investors is to set minimum criteria, such as length of track record or fund size, before considering a manager. The majority of dedicated climate-focused strategies are new, often managed by specialist boutiques who are relatively modest in assets under management (AUM). For instance, a recent survey for ESG-centric hedge fund strategies revealed a median track record duration of just 38 months and a median fund AUM of about $140 million.
This scenario presents a quandary: Should investors relax their requirements, bracing for enhanced due diligence for fledgling managers with shorter track records? Or should they retain their standards, risking a bias towards managers who merely rebrand their older, non-climate-focused products as green?
A final point of contemplation for climate-focused investors is portfolio construction. As the climate transition theme garners increased attention, portfolios combining equity, credit and alternatives exposures may be concentrated in a specific 'climate factor'. This might be exemplified by a strategy like 'long on renewable energy and short on oil and gas'. Though such a stance might yield benefits in the long run, investors should consciously evaluate risks – in 2022 this was a painful tilt to have in portfolios. From the hedge fund perspective, risks like these can be tempered using methods like sector neutrality which are unavailable in the long-only space. However, the ultimate aim should always be to diversify sources of risk and return in search of portfolio robustness to an uncertain future.
As highly active market participants, wielding more than $4 trillion of assets under management (and significantly more on a leveraged basis), hedge funds will play a major role in both driving positive action on climate change and delivering attractive returns from the opportunities created by the climate transition. Witnessing hedge fund strategies evolve with a more pronounced climate-focused approach, not only within long/short equity but across broader contexts, is a positive step indeed but, as with all things climate-related, there is much still to do.
Chris Stevens, CFA is Senior Director within the Diversifying Strategies team at bfinance
Toby Goodworth is Head of Liquid Markets at bfinance