Responsible investment and its many forms, have a lot to thank the long-only world. No one in the industry would disagree that long-only investors gave birth to the foundations of responsible or ethical investment. Even so, responsible investment is still often narrowly thought to refer to a specific type of long-term, buy-and-hold, engagement-heavy equity investing.
But, similar to the world of active fundamental investing, responsible investment is maturing due to segments of the investment management industry that use short-selling as a tool to drive capital and change. They’re converting a nascent long-only investment objective into a mature and regulated investment style that cannot be overlooked by anyone in the industry.
Are there any ESG advantages to short selling?
Short selling can be an excellent tool for achieving three common goals of contemporary responsible investment: mitigating undesired ESG risks, creating an economic impact by influencing the nature of capital flows through ‘active’ investing and regulating companies behaviour around disclosure of their true impact towards sustainability.
A recent report, from the Alternative Investment Management Association (AIMA) and law firm Simmons & Simmons, outlined that short selling is key for responsible investing as shorts are often triggered based on ESG concerns. The report highlights the first advantage - short-selling helps hedge against ESG risks. The paper uses carbon risk as an example to prove how shorting high carbon emitting companies, protects the portfolio against carbon risk. The argument is straightforward, if a company’s value decreases with increased carbon risk or transition risk in the economy, having some short exposure will protect the portfolio the increasing cost of carbon risk.
The second advantage is even simpler but has a large economic impact in aggregate. By shorting laggard companies in an industry, you are taking away capital from that company and investing it in a company or industry that is quintessential for sustainable transition. When this is done in aggregate by the whole alternative investment industry, it acts as a force that supercharges this transition. The increase in cost of capital for the targeted issuer / whole industry, incentives the issuer(s) to protect itself by actively transitioning its business model to be sustainable.
As a third advantage, until regulation matures and is fully implemented, short sellers act as pseudo regulators for the industry. More on this below.
How can Alternative-Investment managers deploy short selling?
Industry based exclusions are a common way to deploy short selling. Many ESG exclusion policies will allow investment managers to short companies in unsustainable industries where the market capitalisation is small enough to make an impact. Velox, for example, allow its investment managers to short companies in Gambling and Predatory Lending. Alongside the increased cost of capital argument, unlike entirely excluding the industry, this keeps the channel of engagement open. Engaging with a short angle allows us to effectively communicate the required changes and have an impact on the transition.
ESG Integration when deployed correctly , allows spotting of the “worst in class” companies. These companies are the laggards in their industry on sustainable transition and are the ones that are slowing the pace of the collective transition. Velox uses its traffic light system to spot the “Red” companies which are the ESG laggards in their industry. Actively shorting these companies allows for engagement, capital to be taken away from the laggards and given to the leaders and hedge against the transition risks of the industry.
Activist Short Selling approach - Poor management, bad environmental records, corruption and a whole other multitude of sins are actively sought out by activist hedge funds looking to hold companies to account. Shorting is a great way of expressing these concerns. The fact that short sellers now also look to actively call out companies that are not meeting the ESG specific standards expected by investors is of additional benefit to society. Since ESG regulation is still in development, these activist hedge funds act as pseudo regulators, calling out the “Greenwashing” tendencies of certain companies.
Given the above, it’s clear that short-sellers are essential for the growth of responsible investment. Therefore to the short-sellers in ESG – May the force be with you.