Many investors have lofty carbon reduction goals, but achieving Net Zero through long-only strategies remains a far-off possibility. Integrating shorting may help them meet their goals more quickly.
Investor demand and regulation are driving the continued growth of sustainable investing, with many investors considering how best to integrate carbon reduction and other ESG goals across their portfolios. At AQR, we have been helping clients achieve their climate objectives since 2017. With over $20 billion in carbon reduction assets under management, we have the experience to help investors on the path to Net Zero. But we didn't stop with carbon reduction. We have also pioneered what we believe is a first of its kind carbon-negative portfolio, helping investors generate climate credits to offset their carbon exposures elsewhere.
AQR has incorporated Governance signals - the "G" of ESG - in our models since the firm was created in 1998, and today over 80% of our ~$140bn[i] in AUM incorporates E, S, and/or G-related signals. We see the inclusion of ESG considerations in our full security selection model as promoting a more holistic approach to understanding a given company's fundamental value, and have published research on this: for example, our paper mapping the ESG-efficient frontier argues that in general, any optimal allocation includes ESG information like the signals in our models as standard.
Over the past two decades, we have made significant further developments in ESG, across the pillars of responsible asset selection and responsible asset ownership we set out in the framework for responsible investing we co-created with the UN PRI, as well as corporate social responsibility. Strategies with explicit ESG-related investment objectives represent ~20% of our firmwide AUM. This has evolved in line with our research: we have investigated the relationship between sustainability and risk, analysed the potential benefits of shorting unsustainable companies, studied whether ESG helps or hurts returns, and most recently, explained how an investment portfolio could dramatically reduce its carbon footprint (i.e. meaningfully lower emissions vs. a benchmark or, in some cases, have outright negative carbon exposure - as we discuss next in this piece, a revolutionary idea in the investment world). Indeed, AQR is managing what we believe to be among the first strategies targeting significant negative carbon exposure: our Sustainable Delphi Long Short Equity Strategy (hereafter "Delphi L/S"). The strategy is available in a variety of vehicles, including a UCITS fund.
For illustrative purposes only.
How can investors significantly reduce or reach net zero emissions?
As we describe in our recent white paper "(Car)Bon Voyage: The Road To Low Carbon Investment Portfolios", we see this feasibly done in three ways: through security selection, carbon offsets (and permits, and similar instruments), or shorting.
- Security Selection: Carbon emissions tend to be concentrated in relatively few industries and companies, so ostensibly even a small adjustment may lead to a large change in portfolio carbon footprint. However, given the concentration, that can be unduly distortive, and given that there are at present no companies with both zero scope 1 and 2 emissions (to say nothing of scope 3!), reaching zero portfolio emissions in this fashion is unrealistic.
- Carbon Offsets: Offsets, permits, and similar instruments hold appeal as a way to claim reduction in portfolio carbon footprint, but are not without controversy: the quality of such instruments is variable. They may also be very costly; certainly permits are more costly than offsets, but even offsets used in this way cannot contribute to financial objectives (since they must be permanently "removed" from the market to fulfil their purpose in offsetting portfolio emissions).
- Shorting: We believe that shorting has a clear ESG use case, and in the context of carbon has three broad applications:
- Useful for hedging climate change risks: A well-constructed long-short portfolio can easily have larger emissions on the short side than on the long side. Such a portfolio - going short securities likely to decrease in price when transition or physical risks materialize and long those likely to be relatively less harmed - may offer an outright hedge against the opposite exposure to such risks elsewhere in one's allocation.
- Offers a path to impact: While the best way to influence a company is by becoming a meaningful shareholder, shorts still offer a more plausible path to impact than simple divestment from the most polluting companies (as we discuss in Hit 'Em Where it Hurts, shorts are useful for attracting the attention of less sustainable companies and may increase the cost of capital of high-emitting issuers).
- Creates carbon credits: Investors can offset carbon emissions of a stock they buy with the emissions of a stock they short, meaning that short sellers have a negative carbon footprint on their own "book", which can be used to offset positive carbon exposure elsewhere in a portfolio. Shorts must be offset in this fashion. Ignoring shorts altogether when calculating a portfolio's carbon footprint is incongruent with other aspects of portfolio accounting: if shorts matter for the returns you earn, the risk exposure you have, and the dividends you receive or have to pay, then they should matter for carbon as well. Moreover, without allowing for the creation of carbon credits, the market's assessment of how much carbon a company emits would vary based on the level of short interest - and with it, the aggregate carbon the market accounts for would vary too.
The broad approaches above all have their pros and cons, and sustainable investors may choose to combine them. However, we believe shorting stands out as an ideal tool to reduce a portfolio's carbon footprint.
Source: AQR. Investment process is subject to change at any time without notice.
How does it translate into a real portfolio?
AQR stands for Applied Quantitative Research, so it was natural that our work on significant emissions reduction should be put into practice. Delphi L/S is one of our first strategies to offer a negative carbon footprint (actually, significantly negative - as of March 2021, €1 invested in Delphi L/S offsets the carbon footprint of approximately €3 of MSCI World Index exposure[ii]).
By way of context, Delphi L/S was launched in November 2012 as a result of our research on low beta and quality anomalies. After studying these phenomena in depth, we decided to launch a strategy that looked for these properties in equity markets while considering the prices of these companies (which is to say, considering the Value factor so as not to overpay for quality). As we describe in Buffett's Alpha, a large portion of Warren Buffett's returns can be explained by exposures to those premiums/anomalies, so we named our strategy "Oracle" (after the Oracle of Omaha). Subsequently almost 3 years ago, we decided to rename it to "Delphi" (after the Ancient Greek oracle). We added the "Sustainable" appellation in Q1 2021 once we began managing the strategy to explicit ESG investment objectives, the full details of which we describe below.
Delphi L/S is an equity strategy which applies a sustainable investment process on both the long and short sides of the portfolio, including the innovative negative carbon portfolio construction technique noted above. The strategy leverages the breadth of our ESG thought leadership as well as a significant history of AQR research on low risk investing. The result is a sustainably-implemented strategy targeting a significant expected return and intended low correlation to other approaches, while also seeking to generate portfolio carbon credits in a highly efficient manner for investors to offset long carbon exposures elsewhere in their portfolios.
Investment pillars seeking
Source: AQR. Investment process is subject to change at any time without notice.
Delphi incorporates the Governance-related signals used in most of our strategies, and so will tend to be long stocks with attractive ESG profiles and short stocks with comparatively weaker ESG characteristics - which we view as a more forceful expression of ESG-related views than a simpler constraint applied only to long positions. That is amplified by the use of active tilting and static and dynamic exclusions, also based on ESG characteristics from third-party ESG ratings providers. The portfolio's long side excludes a set of problematic ESG businesses (fossil fuels, tobacco, and controversial weapons), which all may be shorted unless otherwise prohibited by regulations; it also seeks to exclude the worst ESG-rated ~10% of companies on an ongoing basis, which too may be shorted where the ESG rating aligns with our investment view; and we tilt the portfolio toward better ESG-rated companies such that the average long stock is meaningfully more ESG-attractive than the typical short stock.
The design choices we have made in Delphi represent an alternative course of action, a diversified, academically-grounded solution through which investors may achieve a net zero portfolio target today. AQR is committed to ongoing research in the space, and we will continue to share our research publicly to promote investor education and advance the industry dialogue on key topics. So too we hope to expand our negative carbon capabilities to more strategies and more asset classes, continuing to innovate as the market evolves and companies decarbonize.
The information set forth herein has been obtained or derived from sources believed by AQR Capital Management, LLC ("AQR") to be reliable. However, AQR does not make any representation or warranty, express or implied, as to the information's accuracy or completeness, nor does AQR recommend that the attached information serve as the basis of any investment decision. This document has been provided to you solely for information purposes and does not constitute an offer or solicitation of an offer, or any advice or recommendation, to purchase any securities or other financial instruments, and may not be construed as such. This document is intended exclusively for the use of the person to whom it has been delivered by AQR and it is not to be reproduced or redistributed to any other person. Please refer to the Fund's Prospectus for more information on general terms, risks and fees.
Sustainable investing is qualitative and subjective by nature, and there is no guarantee that the environmental, social and governance ("ESG") criteria utilized, judgment exercised, or techniques employed, by AQR will be successful, or that they will reflect the beliefs or values of any one particular investor. Certain information used to evaluate ESG factors or a company's commitment to, or implementation of, responsible practices is obtained through voluntary or third-party reporting, which may not be accurate or complete. ESG investing can limit the investment opportunities available to a portfolio, such as the exclusion of certain securities or issuers for nonfinancial reasons and, therefore, the portfolio may perform differently than or underperform other similar portfolios that do not apply ESG factors.
AUM information as of June 30, 2021, and represents assets of AQR and its advisory affiliates.
Broad-based securities indices are unmanaged and are not subject to fees and expenses typically associated with managed accounts or investment funds. Investments cannot be made directly into an index.
The Russell 1000 Index is an index of approximately 1,000 of the largest companies in the U.S. equity markets. It comprises over 90% of the total market capitalization of all listed U.S. stocks, and is considered a bellwether index for large cap investing. The Russell 2000 Index is a free float-adjusted market capitalization weighted index that is designed to measure the performance of the Small Cap segment of the U.S. equity universe. The MSCI World Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed markets. The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets.
The information set forth herein has been prepared and issued by AQR Capital Management (Europe) LLP, a UK limited liability partnership with its office at Charles House 5-11, Regent St., London, SW1Y 4LR, which is authorised and regulated by the UK Financial Conduct Authority ("FCA").
AQR in Germany and the European Economic Area is AQR Capital Management (Germany) GmbH, a German limited liability company (Gesellschaft mit beschränkter Haftung; "GmbH"), with registered offices at Maximilianstrasse 13. 80539 Munich, authorized and regulated by the German Federal Financial Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht, „BaFin"), with offices at Marie-Curie-Str. 24-28, 60439, Frankfurt am Main und Graurheindorfer Str. 108, 53117 Bonn to provide the services of investment advice (Anlageberatung) and investment broking (Anlagevermittlung) pursuant to the German Banking Act (Kreditwesengesetz; "KWG"). The Complaint Handling Procedure for clients and prospective clients of AQR in Germany and the European Economic Area can be found here. This document is a marketing document.
[i] Source: AQR. Approximate as of 3/31/2021, includes assets managed by AQR and advisory affiliates.
[ii] As of March 31, 2021, AQR Sustainable Delphi Long-Short Equity Strategy had a Carbon tonnage exposure of -233.6 per $1mm invested, which is -2.9 times the Carbon tonnage exposure of 1mm in the MSCI World at that time