What are the potential risks of a market-neutral approach?
Alongside the potential benefits of market-neutral implementations for climate investing, there are also risks. Among the most significant relates to portfolio construction: the potential for the sought-after neutrality to break down, exposing the strategy to more market directionality than intended. Market-neutral implementation is pursued, in part, by constructing long and short positions such that the net equity exposure is low. However, to achieve this, the beta-adjusted exposure of longs and shorts should be considered in an attempt to minimize the overall equity beta of the approach.
Beyond beta and net exposure, another key consideration is factor exposure. This is the risk that a strategy has an unintended tilt to a factor, such as momentum or value, that becomes out of balance, upsetting the neutrality of the approach. To reduce this risk, it is crucial to position long and short positions within the same sector, which tends to help minimize factor risk. For example, utility stocks tend to trade on factors such as value, whereas clean technology stocks tend to trade on momentum. A long utility, short clean technology trade could therefore embed factor risk consistent with long value and short momentum, creating basis risk, which could upset the neutrality of the approach should one or both factors move unfavorably. By instead constructing longs and shorts within utilities and within clean technology stocks, for example, it is possible to reduce factor risk by being long and short the same factor.
A third concern is that market-neutral implementation may mute the potential returns in unusually strong markets for climate investments. This is more a risk of opportunity cost but remains an important consideration when evaluating whether long-only or market-neutral implementation is appropriate. Notably, the inverse is also worth bearing in mind, as market-neutral implementations might have comparatively shallower drawdowns than those of long-only approaches when climate-related investments are out of favor.
A fourth risk is that market-neutral strategies, like most long/short approaches, employ financial leverage from prime brokers. This can be measured by the gross exposure of the approach, which can often be expected to significantly exceed 100%. In our view, one key consideration is how that leverage is applied. For example, we believe applying leverage to larger, more-liquid stocks poses a reduced level of risk versus applying leverage to smaller, less-liquid stocks. Security types, particularly derivatives, can introduce yet another form of leverage.