For those looking to make an impact investment without the pain of market corrections, the solution can be simple: Buy the best-in-class, short the villains, and keep the portfolio neutral.
Earlier this month, the European Securities and Markets Authority, Esma, warned of further corrections in the stock market. Esma chair Verena Ross said the resilience of the financial system was being tested by “fragile liquidity”. The warning proved justified.
The Dow Jones Industrial Average fell 3 percent last week, driven by negative inflation data and declining confidence in a quick “pivot” by the Fed. That put the blue-chip index one percent lower than in early January. The S&P 500 fell 2.7 percent, and the Nasdaq Composite dropped 1.7 percent.
Underperformance for impact funds
Impact funds in the mixed category - which already had a “significant underperformance” against the MSCI ACWI index in 2022 - also performed “slightly below the competition again last week, but slightly better than the index”, said Ronald van Genderen, senior manager research analyst at Morningstar.
Tristan Elwell, portfolio manager of the ESG Absolute Return Fund at Eco Advisors, however noted that many investors forget that in a falling market, returns can also be made. “Certainly within ESG investing, ‘short-selling’ is still an unexplored profit territory,” he told Investment Officer.
Elwell’s euro-dominated market-neutral long/short strategy ended 2022 on a positive return of 1.6 percent, while the average large-cap ESG fund ended last year with a performance of -14 percent, more than one and a half percent lower than the MSCI ACWI. Since Eco Advisors’ ESG fund launched in 2019, the net annualised return is 4 percent in dollar terms.
Fertile environment for short-selling
According to Elwell, the new economic regime, which he said will be “dominated by tight labour markets, increasing government intervention in the economy, and de-globalisation”, lends itself well to short-selling.
“Corporate profits are being challenged by rising input costs and higher interest rates,” said Elwell. “We are also seeing a trend where the fruits of economic growth are going less to capital, and more to labour.” This has profound implications for investors, said Elwell.
Companies that have underinvested in human capital or supply chain risk management will be at a disadvantage compared to the best-in-class, Elwell says. “The new regime is a ‘blue collar boom, white collar recession’.”
Edging out
The selection of candidates for potential long or short positions is done “purely” based on ESG criteria, Elwell said. “Investors can achieve alpha in a highly volatile and even negative market, by identifying companies that excel in ESG or make great improvements, but also those that cut corners and carry a lot of risk,” said Elwell, who combines the best-in-class and worst-in-class in a single portfolio.
“We look for a composition of long and short positions without bias or risk in the portfolio, even if some long positions are expensive, and some short positions are cheap.”
‘Going short and ESG are compatible’
There is a lot of debate about how short portfolios should be structured. Many investors, Elwell said, have not yet fully understood this.
“We don’t short just to hedge a long position, which I think many people would do. We select shorts because they are the ESG villains, and that makes it much more relevant. In my experience, going short is an interesting way to put pressure on the management of companies,” Elwell said.
Neutrality
The fund has a net market exposure of 13 percent, so returns are only marginally linked to the ups and downs of the stock market. “The aim,” said Elwell, “is to minimise portfolio skews, such as changing growth-to-value ratios, and ensure that net exposure does not change significantly.”
The fund’s beta against the MSCI ACWI has averaged 0.03 since the fund launched in 2019. The fund has a volatility and risk profile similar to the corporate bond market. The Eco Fund’s risk profile and volatility are at 4.4 year-on-year since inception, compared with corporate bonds at 5.2 and equities at nearly 20.
This article also is available in Dutch on InvestmentOfficer.nl.