Alpha Signals and Shorting in an ESG World

Hedge fund industry thought-leaders discuss investment opportunities and challenges within the still-evolving ESG space.

BNP Paribas’ Prime Services business hosted an online panel discussion on potential opportunities for hedge-fund managers within the still-evolving ESG investment space. Moderated by BNP Paribas’ Marlin Naidoo, Global Head of Capital Introduction, “On the Radar: Alpha Signals and Shorting in an ESG World” featured industry experts from Willis Towers Watson, Man Group and AQR Capital Management, who considered ESG-specific topics ranging from risk/return outcomes to short selling and more. Here are some highlights:

What can be done to boost ESG uptake from a quant perspective?

While surveys have long extolled the virtues of ESG-based portfolio building, some skepticism remains, including among those who suggest ESG alpha generation could be tested should current levels of investor demand begin to wane. Part of the issue is the shorter lookback period for ESG relative to other strategies. Panelists suggested that one way to rectify this is to focus on conditioning and retraining the underlying data in order to remove any anomalies, thereby making ESG factors more reliable from a quantitative standpoint.

Where is the alpha within ESG?

Panelists concurred that governance has been the most actionable of ESG components, as borne out by decades of academic research. Despite having relatively shorter sample sizes, though, even environmental and social strategies, such as consumer-facing equities or carbon exposures, have shown real promise across a number of sectors and regions. While equity investing remains the method of choice, panelists see emerging ESG opportunities within corporate and sovereign debt, commodities and other non-stock issues.

How do managers quantify ESG risks/opportunities when using data from third-party analytics providers?

Because ESG scores may vary from one firm to the next, for starters panelists agreed that asset managers should not rely on any single analytics source, but instead obtain all available information from an aggregate of data providers, taking into account materiality and impact as it relates to the specific composition of their own ESG portfolios.

Is there a place for shorting within the ESG portfolio?

Like other aspects of hedge-fund management, firms should be able to make a clear case for shorting ESG, using some of the same criteria that may apply to non-ESG issues. Particularly if one has a diversified, core-allocation portfolio including industries that could be negatively impacted in the event of a global carbon tax or similar regulatory action, then shorting such issues would be a plausible approach to effectively managing overall portfolio risk. Indeed, there’s the notion that shorting certain green-lagging companies may be more impactful than abstaining from ownership altogether. Accordingly, long-short strategies are often best at mitigating climate-related risk and achieving a zero-beta portfolio.

Will shorting opportunities become more prevalent going forward?

While shorting has been primarily climate-focused to date, panelists considered whether an expanded data framework could boost short selling around social/governance issues as well. As S&G portfolios tend to favor very pronounced structural bets to the long side with little turnover, different strategies have been developed to highlight potential short opportunities as they arise, which can often provide managers with a substantial discount.