By Toby Belsom, Director of Investment Practices, PRI
Few would claim that the hedge fund industry has fully embraced responsible investment. Hedge funds remain largely absent from some of the leading collaborative initiatives such as Climate Action 100+ and only a relatively small percentage of PRI’s growing signatory base are hedge funds. As PRI CEO Fiona Reynolds puts it, this group “needs to step up to the plate and engage on systemic issues such as human rights, climate and employees’ issues – something that has been lacking from large sections of this important part of the investment industry.”
Whether they consider themselves hedge funds or not, many signatories either manage, or allocate to investment strategies, that use short positions—an approach that is closely associated with the hedge fund industry. That is why today we have published Shorting and responsible investment: A review. It explores some of the challenges facing asset owners and managers combining responsible investment and shorting and identifies the next steps signatories might want to consider when allocating to an investment strategy that uses short positions.
Shorting and responsible investment
Shorting is a well-established investment strategy which—from the perspective of many within the responsible investment community—is controversial.
This extends to policymakers and corporates who often have concerns regarding transparency surrounding the reporting and purpose of short positions. Clients and asset owners have different perspectives on the ethics of benefiting from short positions and academics express a range of views on the evidence for the liquidity and price transparency benefits this strategy brings to capital markets.
For many the jury is still out on how—and even if —you can combine a robust responsible investment policy and long/short strategies.
In our report, we explore three aspects of RI and long/short strategies: investment decisions, engagement and reporting. The review is intended to trigger and extend the debate that asset owners and investment managers can have around using short positions within portfolios.
Perhaps unsurprisingly, incorporating material E, S, and G issues into investment decisions is well established and understood. Hedge funds have a long history of rooting out false claims of accounting and financial irregularities. As outlined by AIMA, long/short strategies may also be used to hedge against broader risks such as physical climate change risk. As Stephen Kennedy, Senior Portfolio Consultant, Albourne Partners, and Chair of the PRI’s Hedge Fund Committee has commented, “investors have been able to use shorting to hedge systematic exposures within portfolios as well as to various traditional company financial metrics deemed as overpriced. Shorting also allows an investor to hedge systematic ESG exposures as well as to short where various ESG characteristics indicate an investment is overvalued and faces challenges based upon how those factors are managed and/or changed.
Engagement for short strategies proves trickier ground. Rightly, investors following all types of investment strategies are under increasing pressure from stakeholders to consider their role and responsibility as stewards of capital. Investors that use shorting are not exempt from this. Just like building a long-only portfolio, taking a short position (whether physical or synthetic) reflects an economic exposure that has real-world implications for employees, the environment and affected stakeholders. Under these circumstances, engagement to promote better practices should not be an optional extra.
Some approaches to engagement will mirror long-only portfolios, challenging management teams to improve practices through public and private avenues. However, engagement within long/short portfolios does have clear differences. In reality, investment managers with short positions may struggle to gain the ear of management. Indeed, some might argue that if shorting a company generates a profit, your interest is not necessarily aligned to seeing that business improve the very things that have attracted the short position in the first place.
Short positions may also be constructed through instruments such as contracts for differences or other derivatives, where ownership rights are different from investments in securities or issuers. Portfolio turnover may also be high. Corporate engagement can be difficult to implement with such approaches. This does not diminish the need to be a responsible steward of capital and in such cases, investors will need to develop stewardship approaches focused on public advocacy, collaborative action and influencing systemic issues—approaches that are consistent with the PRI’s Active Ownership 2.0 programme.
Reporting the ESG impact of a portfolio is becoming increasingly important to clients and regulators. For those utilising long/short strategies, this can prove challenging. For example, they may invest in asset classes and financial instruments that are not always extensively covered by ESG data providers. As was clear from a recent discussion we had with a leading ESG data provider, there is no industry standard for reporting the ESG impact of portfolios that combine long and short positions.
For example, is it acceptable to report the climate “footprint” of a portfolio by calculating the net greenhouse gas emissions of long and short positions? If such an approach is not consistent and clearly laid out in a fund’s documents and client communications, then doing so could easily be criticised as financial engineering or greenwashing.
Developing a common approach is vital as asset owners and investment managers make commitments around, for example, net-zero targets or contributions to the UN Sustainable Development Goals.
Short selling can provide a valuable way to manage exposures to climate and other ESG risks, while short selling campaigns can target ESG concerns such as issuer governance, environmental issues and human rights abuses. However, for many in the responsible investment community, there are still many questions and challenges to answer. This paper adds to that debate.
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Spotlight on industry voices
Investors and asset owners who allocate to long/short strategies need to step up to the plate and engage on systemic issues such as human rights, climate and employee issues—something that has been lacking from large sections of this important part of the investment industry
Fiona Reynolds, CEO, PRI
Short selling has long been an important tool for managing market risk. This paper explains how it can be incorporated as part of a responsible investment process as well
Michael Cappucci, Managing Director, Harvard Management Company
Investors have been able to use shorting to hedge systematic exposures within portfolios as well as to various traditional company financial metrics deemed as overpriced. Shorting also allows an investor to hedge systematic ESG exposures as well as to short where various ESG characteristics indicate an investment is overvalued and faces challenges based upon how those factors are managed and/or changed
Stephen Kennedy, Senior Portfolio Consultant,Albourne Partners, Chair, PRI Hedge Fund Advisory Committee
Short selling plays an important role in the context of responsible investment. It provides a valuable way to manage exposures to climate and other ESG risks, while short selling campaigns can target ESG concerns such as questionable issuer governance, poor employee safety practices, environmental issues and even alleged human rights abuses. This helps create more transparent, safe markets for investors around the world
Adam Jacobs-Dean, Managing Director, Global Head of Markets, Governance and Innovation, AIMA
This blog is written by PRI staff members and guest contributors. Our goal is to contribute to the broader debate around topical issues and to help showcase some of our research and other work that we undertake in support of our signatories.Please note that although you can expect to find some posts here that broadly accord with the PRI’s official views, the blog authors write in their individual capacity and there is no “house view”. Nor do the views and opinions expressed on this blog constitute financial or other professional advice.If you have any questions, please contact us at [email protected].