ESG's double-hedged sword

15 Sep 2021 | This week, investors short their way to net zero; funds rebranded as sustainable in name only; subjective ESG demands call for more specific approaches. Plus, how do you fold impact assessment into portfolio construction?

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📉 Short your way to net zero? Why not, says AQR. By shorting high-emission companies, investors can subtract negative contributions from portfolios… and crowd out oil (hard to finance drilling if flows into oil stocks go straight to short sellers).

🌹 A flurry of funds are being rebranded as green in name only, reports The WSJ. The main culprits are active fund managers trying to capitalise on finance’s hottest new trend (which may say more about active headwinds than it does ESG tailwinds).

🇪🇺 More about that at last week’s Bloomberg Intelligence webinar, The Inconvenient Truths of ESG ETFs, where it was claimed rebranding contributed to 30% of European ESG ETF growth last year and will account for 50% by 2025.

🇺🇸 As for the US? Bloomberg Intelligence data paint a disappointing picture. If you take out BlackRock, ESG ETF asset accumulation is slow. A big hurdle is investor subjectivity—the solution to which, say the Intelligentsias, is direct indexing.

↔️ It’s a sentiment echoed in the FT, which reports that demand for tailored ESG ETFs—which obscured real complexities by doing both well and good last year—has yielded a divergence in fund approaches that aren’t always understood by investors.

🎯 In the absence of a one-size-fits-all approach, Responsible Investor argues it’s “unfair to make greenwashing accusations.” The gamut covers risk reduction, value alignment, and positive impact. More specificity is needed to address subjectivity.

🌱 DWS’s ex sustainability head says few funds are impact oriented, however, and so do little to mitigate climate change. Bad news given the true cost of climate change, which is lost in E, itself lost in ESG. As we’ve argued: time to unbundle.

🚩 BlackRock’s winning thematic strategy isn’t without pitfalls. The latest event in its ongoing clean energy ETF saga: SPDJI is rebalancing the index underlying $INRG/$ICLN for the second time this year. Balancing purity and liquidity ain’t easy.

Spotlight on Util

🪙 Coinbase is back in the news: this time, for bringing unregulated securities to retail investors. Providing financial access to the retail market is key to social equity, making it both a regulatory and sustainability issue. We put it to the SDG test.

ESG’s double-hedged sword

Could investors short their way to net zero?

Last week, AQR founder and hedge fund manager Cliff Asness wrote a piece titled Shorting Your Way to a Greener Tomorrow, in which he argues ESG investors shouldn’t just invest in the good and divest from the bad, but actively short the worst companies.

Shorting, Asness argues, is a critical and readily available tool in portfolio construction. His is a particularly interesting take on the accounting and measurement of emissions within a long/short fund:

“If one is measuring the carbon footprint in a portfolio, the shorts should be accounted for: one should count the net footprint, which is the value of the long side minus the value of the short side. You cannot ignore the shorts or the system is imbalanced. In fact, if you do anything but count them as reducing emissions exposure, it’s impossibly inconsistent.”

As Matt Levine summarises in Bloomberg’s Money Stuff, there are three ways an investor can claim net-zero climate impact:

  • Buy companies that don’t use any oil (but that’s pretty hard);
  • Buy companies that use oil “in a judicious way,” but plant lots of trees or pay for carbon offsets;
  • Buy companies that use some oil “in a judicious way,” and also short oil companies. Thus the companies you own contribute to climate change, but the companies you short underpin global emissions and so you inverse your impact.

Taken to its end point, this approach has critical implications for oil companies. Short selling creates new shares, which effectively compete with those issued by the company. Someone wanting to buy oil-company shares might, therefore, buy it from a hedge fund manager instead of the company. And if enough people embrace the idea of shorting oil, oil companies could be crowded out: it would be impossible to finance drilling if money went to short sellers instead of drilling projects.

Hedge funds could make short work of ESG

Last week, there was another installment in BlackRock’s microcosmic clean energy ETF saga. For the second time this year, the S&P Global Clean Energy Index underwent a rebalancing that affected the wildly popular iShares Global Clean Energy ETF ($ICLN) and its European UCITS equivalent ($INRG).

On the face of it, that might not have much to do with hedge funds. Bear with me.

The assets under the twin ETFs surged from $1bn at the start of 2019 to over $12bn by the beginning of 2021. An explosion from $1bn to $12bn is pretty remarkable. Even more remarkable is the fact that the ETFs were, until this year tracking an index of only 30 stocks (as was 45% of the total money invested in non-fossil fuel energy ETFs), causing renewable stocks Ørsted and EDP to rally more than 40% in a few months.

Unsurprisingly, it wasn’t long until Société Générale raised the alarm and called for an index rebalancing to address concentration risk and prevent a liquidity crisis. The underlying index—and the ETFs tracking it—were subject to significant rebalancing.

Relief was short-lived. Only last week, Société Générale raised the alarm again. Why? The rebalance had led to a sacrifice in theme purity. While it saw the ETFs’ constituent count rise to 81, that included a 27% allocation to companies with only “some” clean energy involvement. The intensity of clean energy exposure fell 15%.

Back in March, when news of the first reshuffle broke, 7IM portfolio manager Peter Sleep was quoted in the FT as saying “I bet every hedge fund is looking at that list [of iShares Global Clean Energy ETF constituents] to work out where they can buy these stocks so they can sell them short.” Morningstar analyst Kenneth Lamont added, “This gives an opportunity for front-running. The stocks that are going to be bought here are probably already going up in anticipation of this rebalancing.”

If the tradeoff between liquidity/diversity and theme purity is the rich man’s Whac-A-Mole, there’s lots of money to be made in knowing where the moles will pop up next and which stocks stand to win or lose.

While all thematic ETFs are a potential play (Bloomberg Intelligence’s Athanasios Psarofagis suggests cannabis and space are two other susceptible themes based on flows, average market cap, and implied liquidity), it’s particularly true of funds under additional, sometimes contradictory, extra-financial pressures.

Time to rethink risk and reward

The two examples above approach impact from orthogonal directions.

For one, climate change has borne a scientific approach to risk/return. For the other, climate change has borne a trend, the execution of which led to a disconnection from fundamentals (many of the companies exposed to iShares’ $12bn were worth a tenth of that) and volatility. One attracts long-term hedge fund interest; the other, short-term.

We’re at an odd point in time for fiduciary duty: one where the prudent-man rule—the organising principle of investing to date—is coming into conflict with sustainable investing. Part of the problem is that the latter is ill-defined and thus difficult to measure. Last week, in particular, plenty of ink was spilled about the subjectivity of ESG investing. What does it mean? How should it be measured? Why should we do it?

The complexity and confusion are unnecessary. The prudent-man rule and impact can coalesce around a more pragmatic approach to evaluating and integrating impact: namely, by integrating extra-financial risk/return analysis into portfolio management.

First, we need less subjectivity, more specificity

Understanding the symbiotic relationship between capital and impact requires less subjectivity and more specificity. That means evaluating measurable factors in siloes.

Take climate change, for instance. Not all ESG factors are created equal: the urgency of climate change makes risks and returns a critical consideration for any investor—yet they’re often overlooked.

The only thing uniting E, S, and G is that they’re non-financial and desirable. Even that’s a simplification. S and G are desirable—and important—but not as urgent as E, which is (or should be) non-negotiable. Hiding climate change in E, and hiding E in ESG, however, prevents investors from giving the same attention to real-world outcomes as they do to those yielded by financial factors.

Climate risks/returns are as real as financial risks/returns. The former poses risks to shareholders and stakeholders via hard-to-map consequences such as stranded assets (and it won't be easy to trade on Wall Street or the City if they’re underwater), as well as rewards as the energy transition gathers pace.

As Asness points out, returns can be captured by shorting stocks with egregious climate exposure; risks mitigated by doing the same. Even to today’s hedge fund manager, it seems, integrating more dynamic concepts of risk and return is an important part of long-term investing.

The key term is long term. Ironically, short-term short sellers are well positioned to capitalise on thematic ETF rebalances thanks to a failure of index providers to think more concretely about real-world impact. Taking an investment lens to climate change isn’t just making calls on trends or values: it involves thinking about the symbiotic relationship between capital and impact and investing accordingly.

Rather than introducing more variables and confusion to a messy, noisy global economy, measuring impact adds clarity. There’s a social, environmental and financial imperative to make sense of the mess and noise, instead of pretending it doesn’t exist.

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