ESG Investing

Like any other piece of an allocator’s portfolio, ESG factors can provide their hedge fund managers with additional insight that aims to improve risk-adjusted returns. ESG strategies have evolved far beyond simple positive/negative screening, especially in the hedge fund space. With so many new funds launched in recent years, ESG hedge fund strategies are nearly as diverse as their traditional counterparts. Most importantly, ESG hedge funds can offer something their active long-only and passive peers cannot: sustainable and socially responsible returns uncorrelated to stock and bond markets, investments suitable for an ESG mandate with upside and downside capture, and risk mitigation during periods of increased volatility.

While some ESG strategies such as exclusionary screening might reduce their investable universes—ESG hedge fund strategies vary widely, and they offer an array of opportunity sets, even amongst poorly rated firms and issuers. Many ESG long/short strategies utilize ESG data to identify viable short targets (e.g., betting against a hydrocarbon producer with stranded assets). Some ESG hedge funds actively engage with their portfolio firms to improve their ESG profiles and potentially unlock shareholder value. Another has utilized classic activist techniques to enact directorship changes at the U.S.’s largest oil and gas corporation. Rather than limit a portfolio manager’s ability to provide risk-adjusted returns, incorporating ESG into the investment process can potentially enhance a manager’s investment opportunity set.

At its simplest, greenwashing is a marketing ploy—whether it’s a puffed-up PR spin on a notorious polluter, or a fund manager that claims their strategy is more sustainable or impactful than they’re letting on. Greenwashing has become a serious issue as ESG investment strategies increase in popularity. Unsurprisingly, less-than-scrupulous fund managers have found that slapping an ESG label on their investment strategy—without making any real changes to their process—can be a profitable fundraising technique. If allocators are considering ESG hedge fund strategies, it’s important that they understand the manager’s investment process thoroughly and uncover greenwashing during the due diligence process. Not only will these managers’ false ESG claims do nothing for their returns, greenwashing is a major red flag and sign of potential manager risk.

Hedge fund strategies can address climate change in several ways. Many of these funds invest in firms whose technology reduces carbon emissions, addresses the effects of climate change, allows for energy transition to renewables, or tackles “hard-to-decarbonize” industries. Other strategies include active engagement, where managers work with portfolio companies to reduce negative climate impact and risk, and classic activist strategies, which pressure management to enact broad changes at carbon intensive firms. Hedge funds may also trade carbon credits in regulated carbon markets or carbon credit futures in derivatives markets as part of a climate-related strategy.

Climate change will affect all of us, and the accelerating transition to renewables and green technology will fundamentally change our world—Goldman Sachs analysts have projected a $16 trillion investment opportunity through 2030 in this space. Energy transition is also going to leave some traditional producers behind, especially if they are unprepared to adapt, leaving them with costly stranded assets. As a few managers are already demonstrating, some of these firms are ripe for shorting. In disruptive sectors such as energy transition, green technology, and carbon credits, it is crucial to deeply understand firms, technology, raw materials, markets, and competitors, and hedged strategies may also reduce volatility in these turbulent areas, making climate change hedge funds a key aspect of forward-thinking portfolios, whether climate-specific or not.

Totaling the portfolio’s greenhouse gas emissions is perhaps the first and most obvious way to track a fund’s climate impact. However, this can pose several challenges, including coverage, accuracy, backwards-looking data, and impact over time. Carbon intensity data has made great strides—over 13,000 companies (worth 64% of global market capitalization) reported climate change data to the nonprofit Carbon Disclosure Project in 2021, a 37% YoY increase—but challenges remain. Carbon datasets across the board tend to be more widely available for larger firms, which can make it harder to measure small and mid-cap portfolios. Emissions data is also backwards-looking, which makes it important to understand a firm’s climate roadmap, and the data is self-reported, meaning it could be limited in scope, inaccurate or out-of-date. Lastly, investors need to look at carbon intensity from investment entry to exit, especially if a fund’s strategy includes engaging with portfolio firms to reduce climate risk.