Accessing the Climate Transition through Liquid Alternatives

In a preceding article, Are Equity Long/Short Managers Meeting Investors’ ESG and Climate Needs?, we examined how equity L/S hedge funds are addressing issues of ESG integration and reporting. It is not surprising that L/S equity managers (the largest segment of the HF universe) are somewhat ahead of the curve on climate transition matters versus their HF peers. Analysis, data and active ownership (engagement) skills from the long-only world are highly transferable. Indeed, the ability to take short positions expands the ways in which L/S fund managers can exert influence in the real-world, via management pressure or impact on a company’s cost of capital (either in an absolute sense or on a sector-relative basis).

Yet other sub-strategies in the hedge fund sector are also tapping into the climate transition theme. We increasingly see the integration of relevant risks and opportunities in credit hedge funds, macro and multi-strategy funds.

In this follow-up article, we look first at two specific developments that are relevant to hedge fund managers and investors with an eye on climate matters: the emergence of dedicated thematic global macro funds with a focus on climate and the evolution of carbon as an asset class. Finally, we close with three practical questions that should be considered by investors who seek to explore this subject further within hedge fund portfolios.

Wanted: climate-oriented global macro funds

Thematic funds dedicated to the climate transition have proliferated in equities and private markets. To date, there are only a handful of global macro hedge funds with a specific focus on climate. Yet the number is rising and we are anticipating the emergence of more strategies in this group. We would strongly encourage established global macro managers to consider their approach to the subject.

Historically, thematic hedge funds have had a somewhat problematic reputation: many have been sector-specific and they have often been viewed as ‘gimmicky’ or simply too niche to attract long-term investors with strategic allocations. Yet we do not believe the same limitations are likely to be true for strategies focused on the climate transition as a whole. A theme which can be expected to last decades, and impact almost all market sectors, is inherently more credible as a basis for an institutional-quality strategy.

With the ever-present risk of green-washing, investors should be wary of ‘re-badged’ energy or materials-focused sector funds

The thematic global macro funds that have already emerged in this space vary in substance: they may look for opportunities across the energy space (generation, storage, et cetera) and also invest long or short in other sectors such as real estate, insurance and industrials — all of which will be impacted by the transition, with companies advantaged or disadvantaged based on how they are equipped to adapt.

That being said, with the ever-present risk of green-washing, investors should be wary of ‘re-badged’ energy or materials-focused sector funds which have seen an opportunity to pivot to a hot area in order to attract capital.

The ‘carbon asset class’ comes of age

Investors can already gain access to alternative return streams related to the climate transition through trading in the evolving (though still nascent and fragmented) carbon markets. As Emissions Trading Systems have become established across jurisdictions, asset managers can now trade in these markets to access alpha opportunities or mitigate the carbon risk inherent in the rest of their portfolios.

To date, we observe CTAs and multi-strategy funds that have begun trading these markets, albeit typically with quite small exposures relative to the size of the strategies. Recently, we have even seen a small number of dedicated strategies emerging that are dedicated to trading in carbon markets. Often these strategies come with a long bias to the asset class as a strategic decision, both in anticipation of an upward movement in carbon prices and in an attempt to contribute to that movement. Exposure to these markets can be considered beneficial in terms of real-world impact, helping to drive up the price of carbon over time and thereby incentivising change in companies that are buying carbon credits to fulfil their own obligations.

Three climate-related questions for hedge fund investors

1. Are you willing to adjust your typical constraints or requirements? Many strategies in this space are newer and smaller. When doing manager research for investors we have identified compelling relevant hedge fund strategies with fund sizes below US$50 million, which may be lower than the client would otherwise have set for a hedge fund mandate. Requirements for live track records may also need to be more flexible: in many cases, carve-outs of broader strategies will be used to extend track record length. It is important to have a robust analytical approach when examining supposedly ‘representative’ track records.


2. Are you able to access a credible long-list of strategies? Many climate-oriented hedge fund strategies are run by specialist boutiques rather than well-known names. These firms typically have limited marketing budgets. They are also more likely to be smaller and/or newer, as noted above. This combination of factors means that a high proportion of the eligible manager universe will not feature on readily-available manager lists from data providers or consultants. Casting a wide net can hugely increase the likelihood of finding a suitable strategy that fits with the needs of the portfolio.


3. How will you view portfolio-wide concentration in the ‘climate factor’? Investors typically approach the liquid alternatives sector looking for diversification to the traditional exposures they hold; it is important to ensure truly diverse sources of alpha generation. As investors pay more attention to climate transition risks and opportunities across their overall portfolios, we should stay cognisant of the overall concentration in a ‘climate factor’. Even if investing across sectors and in different aspects of the transition, there is a risk that much of the activity will ultimately correlate a core ‘climate risk factor': a trade which could, perhaps, be proxied as ‘long renewable energy, short oil and gas’. While this position may well be rewarded over the long-term, investors should be deliberate about risk-taking. On the hedge fund side, risks should be appropriately managed through techniques such as sector neutrality.
   
   

With over $4 trillion of assets under management (and significantly more on a leveraged basis), the hedge fund space can play a major role in both driving positive action on change and delivering attractive returns from the opportunities created by the climate transition.

As such, it is immensely positive to see hedge fund strategies now offering a clearer approach on this subject, not just in long/short equity but beyond. We would encourage more managers to develop their offerings in this regard, particularly in the global macro space, in view of clients’ evolving needs.

Even now, the recent developments are already making it possible for investors to formulate a credible approach to climate-related matters within a liquid alternatives portfolio. It is always essential to take careful and considered steps, especially within a newer (and somewhat noisy) space. Yet, with robust research in place, caution does not have to come at the expense of progress on this important subject.