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Rachel Shuman
Vice President, Investment Analyst
J.P. Morgan Asset Management

”Shorting overvalued companies with positive ESG profiles can actually help to prevent bubbles in sustainable industries and thereby increase the success of transition over the long term.”

Investors have long allocated to hedge funds in pursuit of alpha and strong risk management. In recent years, it’s become clear that neither of those objectives can be maximized without a commitment to sustainability.

In our hedge fund solutions business, we’ve developed a philosophy for sustainable investing comprised of four key principles:

1. Long-term sustainability trends will create winners and losers.

Many industries are experiencing tremendous disruption from sustainable trends, and the resulting uncertainty about the future presents mispricings and alpha opportunities. Hedge funds can benefit from both sides of these trends by taking long positions in high quality businesses with tailwinds from sustainable themes and taking short positions in unsustainable businesses likely to be left behind as their industries evolve.

Energy transition is a commonly implemented theme, but many investors will overlook or outright exclude the best opportunities – those where the impact is not yet priced in. For example, a high conviction long position in our sustainable long/short strategy is a global utility investing meaningfully in renewables to align with the 2-degree scenario, but whose stock price and ESG ratings do not yet reflect this transition. Conversely, we hold a short position in a highly carbon intensive electric company in Australia where the dividends promised to investors will likely be unsustainable as it fails to transition.

Significant alpha opportunities also exist in less trafficked areas like the health and wellness theme, which encompasses trends from plant-based diets to affordable therapeutics. Among our highest performing positions is a diagnostics company whose faster, less-expensive cancer screening technology is expected to drive significant growth. On the other hand, we held a short position in a biotech company whose business is unsustainable because their therapies are more expensive and less effective than existing alternatives.

2. Shorting is a key tool for building sustainable portfolios. 

While some sustainable investors have determined that short positions and securities lending are out of scope, our view is that shorting is fully compatible with sustainable investing from both an impact and a performance perspective.

From a performance perspective, a long/short strategy allows investors to benefit from both sides of sustainable trends. Shorting is also a crucial portfolio tool to de-risk industry exposure, reduce volatility, and ultimately strengthen risk-adjusted returns. Sustainably minded investors don’t need to sacrifice these risk management benefits in order to achieve their impact objectives.

A long/short approach means allocating capital to companies that are driving positive sustainable improvements and increasing the cost of capital for bad actors who will be negatively impacted by sustainable trends. More broadly, shorting contributes to efficient price discovery and is a key element of well-functioning markets. Shorting overvalued companies with positive ESG profiles can actually help to prevent bubbles in sustainable industries and thereby increase the success of transition over the long term.

3. Engagement is essential to sustainable investing. 

Engagement with both managers and the companies in which they invest is critical to meeting objectives for performance and sustainability. 

Systematically evaluating hedge funds on a comprehensive list of material ESG factors can (a) help investors avoid hedge funds that are more likely to fail and (b) provide a framework for influencing managers to institute best practices. A robust sustainability approach requires regular engagement with managers to advocate for enhancements that strengthen their business and protect their investors. One of our key engagement priorities is encouraging managers to adopt an ESG policy covering how they run their business and how they invest.

Engagement efforts can also be drivers of return and impact at the company level. We have a co-investment alongside one of our activist managers in an agricultural processing company undergoing a technological transformation into a sustainable biorefinery platform. The activist agenda focuses on capital allocation and governance to ensure the transition to producing higher value sustainable products is effective, timely, and well understood by the market.  Another example is in one of our emerging markets portfolios, where the engagement efforts emphasize increased transparency (e.g., enhancing sustainability disclosures) and reduction of operational risk (e.g., strengthening supply chain policies).

4. Alpha and sustainability reinforce one another.

The best ESG hedge funds focus on the intersection of sustainability and alpha – finding where a long-term theme has material implications for asset pricing, sifting through the noise to identify winners and losers, and using engagement to drive positive outcomes. 

While incorporating sustainability is more straightforward (and therefore prevalent) in fundamental equity strategies, we are increasingly seeing sustainability appear as a key priority for macro, quant, credit, and multi-strategy hedge funds as well. Implementation is likely to differ across strategies and asset classes, but the key is identifying managers who are both intentional and alpha-driven in their sustainability approach. 

Some hedge funds are great at identifying sustainable themes and mediocre at investing in them, while others commit “greenwashing” – touting their ESG credentials without credibly applying sustainability in their portfolios. Our goal is to identify managers with high quality investment insights who genuinely integrate sustainability into their investment process as a means of adding alpha and managing risk. This is the foundation for developing hedge fund solutions that meet long-term financial objectives while contributing to a more sustainable world.

Across industries, hedge funds can use a sustainable lens to drive alpha, particularly in transitioning companies where the impact of sustainable themes (good and bad), the ability to short, and the value of engagement remain underappreciated by the market.


You can hear more from Rachel at the Women Asset Management Summit on September 8th 2021. You can view the full agenda and register for your free place here.