Climate investing: The case for a market-neutral approach

Integrating climate change into portfolios

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. As we mentioned earlier, one path is long-only implementation, or investing only in companies perceived to be climate “winners.” 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. A market-neutral approach may provide an alternative path to investing in climate, while reducing beta, factor, and drawdown risks.

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 ESG-mandated strategies and exchange-traded funds (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 significant inefficiencies and opportunities that a market-neutral, long/short strategy may be able to exploit.

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. One of 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 so 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 hypothetical 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, we believe 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 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.