However, at a time where the urgency of issues such as climate change has never been so front-and-centre for investors and regulators, members of the alternative asset management industry are calling for short selling to be considered another tool to address them, which has generated debate and a degree of controversy in the sustainable investment arena.
In an environment where rising inflation and interest rates are taking a toll on growth-heavy long-only ESG funds, some industry experts believe that liquid alternatives such as ESG long/short funds could provide climate-conscious investors with diversification and a portfolio hedge against a potential market downturn.
“ESG funds should come out with a wider range of products that are more suited to a volatile recessionary environment rather than just an amazing bull run in growth stocks,” said James Penny, CIO at TAM Asset Management.
“If ESG can become a little bit more sophisticated and offer clients a bit more in liquid alternatives, better diversification exposure, then I think the ESG market will fare really well or fare much better than it currently is. Shorting is potentially frowned upon, but I think it could be part of the next wave of ESG investments,” he added.
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In theory, liquid alternatives can help mitigate drawdowns in bear markets while providing some upside potential across various market conditions. However, the decade following the Global Financial Crisis saw the longest-ever bull-market run, leading to disappointing performance from long/short funds.
“Shorting has been hard in recent years so demand for even non-ESG long/short funds has been low. But we have seen several new launches in this space over the last couple of years as well as existing strategies being adapted to integrate ESG factors or include a sustainable goal,” said Francesco Paganelli, senior manager research analyst at Morningstar.
That said, it is still very early days. According to Morningstar, there are currently only around 100 funds classified as SFDR Article 8 or 9 in the entire long/short and market neutral complex.
Cost of capital ramp up for the ‘bad guys’
In a recent report, the Managed Funds Association said that short selling could help reallocate $50-140bn of capital away from the most heavily polluting companies, or reduce capital investment by 3 to 8%. This equates to 19% of the total capital ($755bn) invested in green energy sources in 2021.
In the foreword of the study, Michael Capucci, managing director of sustainable investing at the HMC, the asset manager of the $53bn Harvard University endowment, wrote that shorting securities offers two clear benefits.
“First, it further increases selling pressure on a specific security. Second, it allows investors the ability to become shareholders for change in a company without creating more ESG risk in their portfolio,” he explained.
“To the same degree that owning a security helps a company finance itself and gives the owner a carbon footprint, holding a short position hinders a company’s finances and gives that holder a negative carbon footprint.”
The Alternative Investment Management Association has also argued that short selling, if performed by enough market participants, could increase the cost of capital for high-emitting companies and incentivise them to protect themselves against carbon risks by actively transitioning their business models to be less carbon-intensive.
“We think shorting the bad guys is an effective way to ramp up their cost of capital and also to put additional pressure on management,” said Robert Furdak, CIO for responsible investment at Man Group.
“We think engagement via long positions is the best way to influence a company, but by going short you generally get management’s attention and can exercise more influence than if you were to divest.”
Doubts over real economy impact
However, this theory has been questioned by some sustainable investment experts. Rumi Mahmood, vice president of ESG and climate fund research at MSCI, has previously raised doubts about the hedge fund industry’s claim that short selling is an effective strategy to implement ESG investing.
Speaking to Investment Week, he said: “Shorting does have a role to play in ESG risk management, and can be implemented as part of fiduciary duty in managing financially material ESG risks, however, using shorting as a way to achieving real world ESG impact is yet to be widely evidenced and adopted.”
My-Linh Ngo, head of ESG investment at BlueBay Asset Management, agreed. “In the context of carbon emissions, shorting does not necessarily result in a reduction in emissions in the real world. In that sense, emissions cannot be offset through short positions, as the risk remains,” she said.
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With regards to whether shorting a company with a poor ESG record will raise its cost of capital, Mahmood said there is little evidence to support this claim. “An average increase of shorting demand leading to a rise in cost of capital and a subsequent reduction in company emissions is yet to be evidenced for a broader market,” he said.
“In theory, the cost of capital would increase, all else being equal – so versus a purely exclusionary strategy it may be a more effective tool,” said Paganelli, adding that the link between short selling and the reduction of carbon emissions in the real economy “is flimsy at best”.
Furdak shared similar views, and explained that if you are accounting for the carbon emissions of a company you invest in, “in the purest sense, short selling does not take any carbon out of the atmosphere”.
“It is more of a secondary effect – by increasing the company’s cost of capital, you can make projects that they are considering and that may be bad for the environment NPV negative and uninvestable,” he said.
The debate around short selling for ESG has also raised questions around alignment of investor interests with good corporate conduct. Part of the problem, according to analysts, is the lack of obvious alignment between shorting bad ESG stocks and the goal of better corporate conduct.
“There may be unintended risks associated with, or conflicts arising from the dual goal of improving corporate conduct and generating alpha,” said Paganelli.
“The general point is that it is really crucial to clarify what is the approach to short selling the manager has adopted and how risks are managed, how and to what extent ESG factors are integrated in the stock selection process and what are the portfolio implications, as well as what the manager is ultimately trying to achieve.”
Calls for greater regulatory clarity
In the midst of a regulatory crackdown on any and all ESG claims, the lack of transparency could be the biggest greenwashing risk for long/short funds, which are secretive in nature. This issue is even greater for hedge funds in jurisdictions where regulators do not have strong disclosure requirements, which raises the risk, Furdak said.
“Best practice would be to provide full transparency to avoid misleading representation. This may mean reporting both long and short exposures to ESG factors separately, alongside any aggregation approaches which may include netting of long/short positions,” said Ngo.
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Most industry experts, both supporters and detractors, agree on the need for regulators to provide better guidance for shorting activities in portfolios.
“Often they are forgotten, with many requirements written with a long only bias. The ambiguity is not helpful when investors are required under ESG regulations to do portfolio level reporting. Take the EU’s SFDR regulation for instance, where there is little explicit guidance on how to account for shorts,” Ngo added.
“Short-selling should be integrated into regulation, but should be done so in a thoughtful way. We are encouraged to see European regulators begin to consult with the industry on the role of derivatives and short selling in sustainable investing,” said Furdak.
Given that transparency has been a core focus of European and more recently US financial disclosure regulations, Mahmood expects that eventual guidance on short positions could also follow.