Other, classic hedge fund strategies are emerging as a sort of quiet ESG. These strategies aren’t necessarily being deployed through a purely ESG lens, but the ways in which they can be used to manage risk in a portfolio can have significant ESG-positive benefits as well. In May, the Institutional Investors Group on Climate Change issued a paper designed to start a discussion around the use of derivatives and shorting in ESG strategies. The paper argues that both of these tools — commonly used in hedge fund strategies — can support net-zero commitments by separating financial risk management from net-zero alignment.
This theory of portfolio construction could help solve the fiduciary issues that come from engagement campaigns but it’s not definitive. The findings also create an opening for opportunistic strategies to be included more readily within ESG-oriented portfolios.
But some remain wary of finding more use cases for shorting and derivatives, which some consider to be controversial investment tools. MSCI published a report in April voicing skepticism of shorting and ESG. The investment research firm said without careful and fully transparent reporting, it will be challenging to fully understand the intent of long/short ESG portfolios and whether they are effectively meeting their stated goals.
Still, HITE’s Mr. Jampel noted that long-only ESG would limit the investment strategies available to allocators. Shorting could support investors’ ability to make change through investment, Mr. Jampel said, because it removes the conflict of interest involved in holding on to high emitters and hoping engagement will work. What’s more, it also provides a more authentic picture of the emissions in a portfolio. A short position would indicate that a company isn’t expected to materially improve its sustainability rather than holding on to an ESG laggard and hoping for the best.
“We contend that if you’re looking to measure the carbon intensity of a portfolio, shorts should be counted as a negative against other positive metrics you might have in your long book,” Mr. Jampel said.
Another classic strategy — merger arbitrage — is emerging as a way to improve ESG scores in a portfolio.
New York-based quantitative investment firm Versor Investments has analyzed the impact of mergers on ESG scores and come away with some notable findings.
“The standard approach is to invest with the goal of picking the highest ESG scores or finding significant improvements in ESG scores,” said Deepak Gurnani, founder and managing partner of Versor Investments, which had $3.4 billion in AUM as of June 30. “There is a lot of debate about whether that actually works or not. Our approach uses merger arbitrage. We have been able to show that merger arbitrage improved ESG scores in a statistically significant way. So we have been able to incorporate that in our quantitative and risk models as a consideration.”
Typically, Mr. Gurnani said, the target of a merger has a lower ESG score than the acquirer. Once the deal is complete and the company is absorbed, their ESG practices tend to improve as does the total score of the combined entity.
“We typically measure over a two-year period — one year before the announcement and one year after the completion,” he said. “A typical deal takes about four to five months. So within a 30-month period, we typically see that the improvement in scores is better than the sector average.”
That finding points to an ESG improvement many allocators may not even realize they have in their portfolio because merger arbitrage as a strategy doesn’t have to be done through an ESG-specific lens. Mr. Gurnani added that over time, merger arbitrage may take on more of an ESG tilt naturally because more companies are including discussion of ESG factors in their M&A plans.
Mr. Gurnani said this could be broadly beneficial for ESG because it can move the transition ahead without some of the issues and inertia embedded in other approaches. “From our perspective, the focus should be on strategies that improve the ESG scores rather than maintain the status quo,” he said.