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AS THE EVIDENCE OF CLIMATE CHANGE AND ITS IMPACT ON MARKETS GROWS, asset owners are increasingly engaged in addressing the investment implications. But questions remain on how to invest in this emerging megatrend. Here, we share our views and highlight the potential benefits and risks of market-neutral approaches to climate investing — including their potential to better capture inefficiencies and mitigate risks.
The impacts of climate change go far beyond weather. In our view, climate change is a macro catalyst that has the potential to disrupt entire industries. It has already led to large-scale changes in regulations, consumer preferences, technology, clean energy, insurance, housing, demographics, and data on a global scale. We believe most companies have some degree of climate exposure, creating both risks and opportunities for their business models.
However, not all companies are able to respond to these risks and opportunities equally, in the same time frame, or at a reasonable cost, producing relative winners to go long and relative losers to go short. This uneven impact on industries and companies — and their unequal ability to respond — underpins our rationale that climate is perhaps the most widespread macro catalyst for change facing companies today. For that reason, we believe it is an important organizing principle for investing.
Even as this case for investing in climate increasingly resonates with asset owners, the question of how to go about it presents an important fork in the road. One path is long-only implementation. We believe there are situations in which this method makes sense over a longer time horizon. But there is also the potential for the beta and volatility associated with this approach to lead to meaningful drawdowns in the shorter term. Importantly, climate-sensitive sectors, such as energy and technology, can be highly volatile in the short run when they are out of favor. One approach that seeks to dampen some of that volatility is a market-neutral implementation, which represents the other path.
We believe there are two distinct benefits to a market-neutral approach to climate investing. The first is its wide opportunity set. The second is the potential to generate uncorrelated absolute returns with less volatility.
Market neutral’s broader climate opportunity set1
A long-only approach can seek to invest in companies that benefit from their strategy for navigating climate risks and opportunities. But what about all those that do not benefit or are likely to benefit less? Market-neutral strategies, which can also take short positions, can seek to capitalize on both climate winners and climate losers.
Furthermore, the wall of capital pursuing ESG opportunities has helped long-only climate strategies to date but also has had unintended consequences. This influx of capital is “good” in that it finances companies that we believe are already positively contributing to the mitigation of and/ or adaptation to climate change. However, it mostly affects companies that currently meet materiality thresholds for inclusion in today’s ESGmandated strategies and ETFs. These approaches exclude companies that do not meet those metrics but are actively making investments in research and development, changing product lines, and transforming business models to move toward a greener world.
We believe the backward-looking nature of these approaches ignores the future, resulting in a large segment of the market being underappreciated. This creates an unusual situation, as one of the basic tenets of investing is valuing a company based on the discounted value of its future cash flows. By only placing a high value on a company’s ESG credentials today, including using them as the basis for negative screens, investors may be ignoring the ESG winners of tomorrow. In our view, this market dynamic has generated a significant inefficiency and opportunity for a market-neutral, long/short strategy to seek to exploit in the form of “false negatives” to go long and “false positives” to go short.
The long/short climate opportunity
“False negatives” represent long opportunities in companies that, in our view, are successfully transitioning their business models to be more insulated from the impacts of climate change, have compelling fundamentals, and are trading at attractive valuations, in part due to the fact that they do not meet the current bar for inclusion in ESG-mandated approaches today. An example would be an automotive company that is successfully pivoting to the production and sale of electric vehicles (EVs), but whose EV revenues do not meet the common 50% or greater threshold for inclusion in an impact approach, even if it will likely meet those thresholds within an investable time horizon.
In contrast, “false positives” are short opportunities in companies that currently appear to be climate-advantaged but have poor or deteriorating fundamentals, do not have sustainable competitive advantages, and trade at elevated valuations, in part because they meet materiality thresholds for inclusion in ESG-mandated approaches. An example of a company with this “halo effect” would be an EV-focused SPAC that we believe does not have a durable competitive advantage in a space that is ripe with competition from both legacy companies and new entrants.
Figure 1 shows how we view the long/short climate opportunity set, including the “false negatives” and “false positives” described above, as well as “true positives” and “true negatives” that we believe represent long and short opportunities, respectively.
In summary, we think the long/short opportunity set is much broader than that of many other impact, thematic, or long-only climate strategies. Moreover, we believe today’s environment creates a growing dispersion between relative price and value, offering long and short opportunities within the climate-change-based themes outlined in Figure 2.
Market-neutral climate investing’s potential for absolute returns
The second primary benefit of a market-neutral implementation is its potential to generate absolute returns with less volatility and shallower drawdowns in periods when climate-driven investments are out of favor. This is an important consideration when investing in climate because many of the sectors, such as energy and technology, can be highly volatile at times. With a long enough time horizon, a long-only approach might be able to achieve expected returns, but the volatility and drawdown profile in the medium term may be too great for many investors to bear. By seeking a low net exposure and low equity beta, coupled with using a robust risk-management framework, market-neutral implementations can potentially mitigate these risks.
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.
We believe that climate change is already impacting most companies, making it among the largest macro catalysts for dispersion. In pursuit of this dispersion, the initial wall of capital has generally taken the form of long-only, thematic ESG, or climate approaches. Importantly, we do think there is a role for taking a long-only approach to climate investing: it focuses on companies widely accepted as promoting climate mitigation and/or adaption today. In addition, it may be an effective way to capture returns associated with climate change over the long term for those who can withstand the volatility.
However, we also believe there is a significant case for taking a long/ short, market-neutral approach to climate. Crucially, it has a wider opportunity set that includes the progress and likely future climate impact of companies, capturing the inefficiencies created by the backward-looking nature of many existing ESG approaches. Furthermore, it has the potential to mute the downside risks associated with a long-only approach when climate-driven investments are out of favor. Finally, in our view, a market-neutral implementation could be a good fit for investors looking for low-net, low-beta strategies with a potentially low correlation to traditional global equities.
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1While ESG factors are a consideration when determining allocations to individual companies, they will not necessarily result in the exclusion of an issuer or security from the investment universe. Strategies may make short investments in climate disadvantaged companies with a relatively weak or weakening position with respect to climate mitigation and/or climate adaption and consequently may profit from the negative effects of climate change. | 2Source: Wellington Management. For illustrative purposes only. Examples intended to be illustrative of the types of themes and companies in the opportunity set only. There can be no assurance an approach will achieve its investment objectives or avoid significant losses.