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Green Investments Surge: Inside Hedge Funds' Strategic ESG Plays


Lauren Miller

May 5, 2024 - 13:40 pm


Navigating the Green: Hedge Funds’ Strategic Bets on ESG Stocks


(Bloomberg) -- With the increasing interest in sustainable investing, eco-conscious investors might want to gain insights into how hedge funds' derivative positions could indicate the trajectory of their green equity investments. An enlightening academic study, delving into a decade's worth of hedge fund data, sheds light on this very premise.

This extensive research, which comprehensively examines data from over 1,900 hedge fund firms until 2022, puts forth the findings that hedge fund managers' accumulated positions in put and call options over ‘green’ equities have the potential to serve as reliable predictors for the stock's forthcoming performance. As elucidated by George Aragon, an esteemed professor at Arizona State University and a contributing author of the study, these option positions are indicative of the expected future returns of the stock in question.

In the wake of recent performances, the merits of environmentally-focused investment strategies have been under intense scrutiny. The S&P Global Clean Energy Index experienced a precipitous decline by over 20 percent in the immediate past year due to climbing interest rates inflicting pain on capital-heavy green projects. This year’s trajectory followed a similar downtrend, registering an additional 12 percent downfall. When juxtaposed with the S&P 500’s approximately 30 percent climb since the beginning of 2023, the contrast becomes starkly apparent.

This disparity in returns has not gone unnoticed within political realms, especially among high-profile Republicans, who capitalized on such data to critique green investing. Describing it as a failure to adhere to portfolio managers' fiduciary responsibilities, it has incited legal confrontations and outright prohibitions against the broader environmental, social, and governance (ESG) investment movement.

Amid these developments, the investment strategies adopted by hedge funds in relation to green stocks take on heightened significance. The research article, interestingly titled "Are Hedge Funds Exploiting Climate Concerns?", posits a singular focus among hedge funds on the fiduciary aspect when making green investments, suggesting a lack of ‘nonpecuniary preferences’ in their financial decisions.

The study credits hedge funds with a pronounced aptitude for discerning shifts in sentiment and valuation around green stocks and effectively capitalizing on these variations. In instances where public interest in climate change diminishes, which is determined by analyzing the volume of climate-related news coverage, hedge funds strategically employ put options to execute sales at predetermined prices as the value of green equities recedes.

Conversely, a resurgence in climate change interest prompts hedge funds to turn to call options, which permit purchases at set prices in a bullish market. Professor Aragon, without identifying any specific hedge fund, communicated that these investment managers utilized sophisticated financial instruments like options to manifest their enhanced proficiency in interpreting climate-conscious sentiment, predicting its subsequent impact on prices surrounding green stocks, and then placing informed bets accordingly.

For other investors aiming to replicate such strategies, Aragon points to the concentration of these option holdings as a vital indicator. He explains that a mere 10 percent increment in the proportion of hedge funds holding put options on eco-friendly stocks could portend a nearly 17 percent droop in the stock's price in the succeeding quarter. Notably, such a price shift is benchmark-adjusted, denoting an over-and-above slide compared to other stocks of analogous attributes.

In the same vein, the professor illustrates that analogous increment in the proportion of hedge funds that invest in call options on green stocks might signal an anticipated benchmark-adjusted upwards shift approximating 6 percent for the stock price over the subsequent quarter.

The curatorship of the research represented a collaboration among academics, including Yuxiang Jiang from the Southwestern University of Finance and Economics, Juha Joenvaara of Aalto University, and Cristian Tiu from the University at Buffalo. These scholars gauged the barometer of climate concern by scrutinizing newsflow originating from leading U.S. news outlets.

Expanding their thesis, the researchers also delved into various aspects of how hedge funds engage with green investment tactics. One aspect of this examination entailed analyzing how adept hedge funds are with merely long stakes in green equities, probing whether they simply possess a superior knack for stock-picking. By crafting “copycat portfolios” reflective of stock holdings reported in hedge funds' regulatory 13F filings, the academics could juxtapose their performance against similar portfolios embodying the holdings of "brown" hedge funds—defined as those historically less successful when green stocks flourish—as well as against a benchmark market portfolio of green stocks.

Surprisingly, the "green" replicated portfolios achieved a "marginally significant" outperformance over the market portfolio by 1 percent. However, when juxtaposed against the "brown" portfolios, the superiority in performance exceeded 5 percent. Professor Aragon highlighted an even more noteworthy achievement. Hedge funds categorized as "green" by the researchers—determined through an analysis based on their return patterns rather than external labels or marketing—outperformed their "brown" counterparts by an astonishing 7 percent on an annualized basis.

Aragon concluded from the findings that it’s very plausible certain hedge funds are capitalizing on investor climate apprehensions to create what is known in the investment world as alpha, which represents the ability to beat the market and achieve superior returns.

Completing the discourse, Justina Lee lent her assistance in the compiling of insights for the study.

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