The rise of green hedge funds: is long-short the right play for the climate transition?

Are big investors leaving returns, and impact, on the table by not embracing the slew of new strategies?

In 2007, James Hulse helped set up the world’s first climate hedge fund, the Cumulus Climate Fund. It was long before the so-called ‘mainstreaming’ of ESG, and Hulse, who now runs Hindsight Consultants, says there was a misconception by many at the time that the fund was about ethics rather than addressing the “fundamental change” looming on the horizon.

The fund closed the following year when failed US investment bank Bear Stearns pulled its money as the financial crisis hit. 

Hulse, however, is still adamant that a long-short strategy is “fundamentally the right structure to play out climate change”. 

“Anybody trying to play it from a long-only point of view is probably going to lose money,” he says, arguing that – as climate change and the decarbonisation required to tackle it both entail such profound market disruption – making money will essentially require betting against the status quo.

And there are signs this theory could be playing out. A long-short ‘Carbon Offset’ fund set up by HITE Hedge Asset Management in the US returned an impressive 28% in 2020.  The performance was largely driven by last year’s precipitous fall in oil prices, but the strategy, which shorts carbon intensive energy firms most exposed to the climate transition, has annualised returns of 12.5% since its inception in June 2018.

‘You want to penalise the bad, reward the good and use the stick and carrots of your capital to give good outcomes’ – Anthony Clake, Marshall Wace

Even more impressive is the 58% return achieved last year by FFI Advisors’ Energy Transition Long-Short fund, which currently runs around $15m and has achieved annualised returns of 33% since it launched in 2019. 

The potential allure of such returns is obvious, but representatives of both funds acknowledge a degree of unease in the responsible investment world when it comes to short selling. 

Arnold Stifel, Head of Business Development at FFI Advisors, tells RI that there is perhaps an “extra hurdle” to demonstrate that what it does has a purpose beyond profit; although HITE founder and co-CIO James Jampel says the reluctance goes beyond responsible investors: “Most investors do not invest in hedge funds, period,” he says. 

The topic of shorting can be seen as “contentious”, agrees Marisol Hernandez Salazar, who spent four years as Head of Asset Owners at the Principles for Responsible Investment. For non-specialists especially, she says, the practice can be associated with short-termism and greed. The recent GameStop debacle highlights the general antipathy shown towards hedge funds by many.

But in the last year, some major players have also moved into the space, offering ESG- and climate-focused hedge fund strategies.

Last summer, BNP Paribas Asset Management launched its Environmental Absolute Return Thematic fund (EARTH), a long-short equity fund targeting companies “facing or addressing significant environmental challenges”. It currently runs just over $470m, and has achieved returns of 48% since launch.

The strategy primarily shorts heavy emitters that are “structurally challenged”, says its co-Lead Portfolio Manager, Edward Lees. He adds that his team can also short the renewables sector “if we think things are getting a little overheated”, explaining: “It’s important to have a ‘net green’ stance, but still protect yourself and allow yourself to be in the green sector even when it might trend downward”.

Hedge fund giant Marshall Wace launched its first ESG strategy last year, which excludes long investments in securities that do not meet certain parameters, such as weapons, and shorts securities such as thermal coal, alcohol, pornography and tobacco products. The rest of the investment universe is open for long or short investments.

The fund ran $430m as of March and has returned 3.6% in the year to date and 5.87% since its launch in July. 

Anthony Clake, a partner at the firm, describes the interest from institutional investors in the fund as “bigger than expected”, and believes that shorting is “a really good fit for ESG-based investing”.

“There are winners and losers [in ESG], so you need to have longs and shorts – that is what alpha is effectively,” he says. “You want to penalise the bad, reward the good and use the stick and carrots of your capital to give good outcomes.”

When it comes to climate, Eric Markowitz, Director of Research at US hedge fund WormCapital, which runs a long-short strategy that invests in disruptors across sectors and technologies, says there are a “lot of opportunities for big institutional investors to align their investment thesis with the energy transition, both on the long the short side”.

Despite this, many big pension funds, particularly in the US, he says, “continue to be fairly heavily invested in oil and gas”. 

Think tank Carbon Tracker recently published a study which found that since 2011, the energy sector has underperformed MSCI’s All Country World Index by 70%. HITE’s Jampel tells RI that betting against the sector over this period would have been “one of the greatest shorts [in history]”, and is a position he wished he’d taken. 

Shorting carbon intensive firms is also a way to reduce exposure to transition risk, says Jampel. HITE’s fund, he claims, allows investors that “can’t or won’t” divest fossil fuels to offset that risk. “The solution is to allocate to our fund, which has a negative carbon risk and allows you to essentially divest, but without the pain and suffering of going through that process”, he tells RI.

The reasoning behind this runs as follows: If exiting fossil fuels brings the associated climate risk level to zero, then betting against the sector would generate a ‘negative’ risk level, because the investor would actually benefit from poor performance, rather than just avoid it. Such a strategy could offer investors the potential to offset carbon risk in other parts of their portfolios where divestment is harder, such as in passive funds. 

Beyond risk, short selling also offers an opportunity to achieve impact, according to Chris Ito, CEO at FFI Advisors, who wrote recently that shorting has long been an effective way to put companies “on notice”. He argues that this approach can also be harnessed by “socially responsible and impact investors” to “penalise companies for harmful business practices”.

In a position paper published last year, the Alternative Investment Management Association describes how short selling, if done at “sufficient scale”, might increase the cost of capital for companies. 

“If taking a long position in an asset – decreasing the issuer’s cost of capital – can collectively create an ‘adverse’ ESG impact, it stands to reason that taking a short position in the same asset – and thus increasing the issuer’s cost of capital – can collectively create a positive ESG impact”, the trade body wrote. 

But if shorting is the right ‘play’ for the transition, how easy is it to identify the winners and the losers

HITE’s Jampel tells RI that, for now, his fund focuses on picking out the losers rather than trying to divine winners. Green stocks, he says, carry “tremendous risks” at the moment, with hype around the climate transition creating frothy markets. He compares it to the dot-com bubble: everyone knew the internet was going to take over in the early 2000s and the consequent excessive speculation in tech start-ups, and the assumption that all companies positioned for the trend would be successful, resulted in a major crash. He points to the valuation of electric vehicle companies like Tesla, describing them as “unmoored to anything”. “They can’t be all worth that much money because all their plans, if executed, would overlap”, he says.

WormCapital’s Markovitz agrees that there will be “potentially very few” winners in the climate transition, suggesting that there “tends to be a ‘winner takes all’ or ‘winner takes most’ type of market-share dynamic”. 

But FFI Advisors’ strategy takes long positions exclusively on green stocks – something Stifel describes as the “easier”, but not easy, part of its approach. 

On shorting, he reflects: “You can be very, very right on something; you can put a short on, but it just doesn't work”, noting the John Maynard Keynes quote ‘markets can remain irrational longer than you can remain solvent’. The Gamestop episode showed how short squeezes can hurt hedge funds. 

As a result, the short component of FFI’s fund is a “smaller asymmetrical part of the portfolio”, he says, which provides “a little bit more juice”. The fund is long around 40 names and short around 20.

Stifel tells RI he’d like to take short positions on oil majors like Exxon, which have done little to embrace the energy transition, but says it’s difficult as the oil giant “could just as easily go to $70 as it could to $30 given underlying oil volatility” (Exxon shares currently trade at around $60). What the fund does, he says, is run very conservative shorts on firms that “have the weakest financials based on their E&P [exploration & production] profiles with these stranded assets that are not going to work out for them.”

Hedge funds look set to continue pushing into green investing, offering to navigate the disruption posed by the low-carbon transition by betting against intransigent firms and offsetting carbon risk. But, even if they prove all this to be possible, and if investors get past the practical difficulties involved in short selling, will the responsible investment world ever get over its queasiness?