Can a long short fund be sustainable?
Can a long short fund be sustainable?
Sustainable funds are an increasingly popular choice for long-only equity investors but can a long short product also be sustainable?
I believe the simple answer is yes. I care about risk, return, and impact and I believe clients do as well.
There is no obvious reason to assume that just because an investor has no appetite for market risk, they have no desire to achieve a sustainability purpose alongside their traditional return targets.
I also believe a process which embeds sophisticated sustainability criteria alongside fundamental analysis is simple logic. At the start of my career, sustainability reports did not exist and the bulk of information we got from companies came from reported financial statements. This dynamic has clearly changed.
Now, with dedicated sustainability reports and integrated reporting, we have far more information about companies and their aspirations than we did 20 years ago. The advent of this data, combined with a change in investors’ needs, creates the perfect environment for an enhancement to a process. Investors are asking questions about sustainability and companies are making the information available.
Does shorting have a role in a sustainable product?
Shorting (or short-selling) a stock, in order to profit if its value falls, can be a valuable tool for a sustainable investor. This reflects my core belief that as a society we won’t solve any of the issues highlighted by sustainability research through exclusions alone. Removing companies from the debate and scrutiny of public markets does not cut carbon emissions or improve labour standards. Rather, it hides activities from scrutiny.
The act of shorting expresses a stronger view than simply not owning something, as would be the case in a long-only portfolio. In addition, shorting results in an increased cost of capital for companies. Over time, it may lead to changes in a company’s behaviours to address issues that are leading to high levels of shorting against them.
There is a balance to be struck between a need to do no serious harm in the near term, an understanding of a company’s willingness and potential to change, and a desire to increase the cost of capital for those who are slow to transition or change. A long short sustainability process that equally scrutinises long and short positions allows this balance to be struck.
What does sustainability mean?
To me, sustainability is a broad and evolving topic. It covers both what companies do and how they do it. Our sustainability analysis aims to capture the risks and opportunities both to a company and an investment which are not typically represented in financial statements. In my view, sustainability analysis has the ability to impact both near-term earnings forecasts and the valuation multiple companies trade on. Therefore it has a role in stock selection full stop, whether you are looking to go long and benefit from mispriced potential, or short supported by underappreciated risks.
Having decided this was an important facet to integrate into our work, I had to decide how we would approach it as a team. There were lots of options. A relatively straightforward, simplistic route would be to use third party ratings to either mechanically adjust target prices or to place restrictions on portfolio construction. The most complex would mean adopting a fully integrated approach.
This latter path requires the development of a framework which uses sustainability analysis to help answer the core questions we use to identify attractive investment opportunities. A single score cannot capture the nuances of sustainability as an add-on at the end of a process.
I believed that to answer the complex questions raised by sustainability analysis we had to become truly integrated. We had to design a framework which enabled us to answer two key questions:
- Would society write a company a cheque or send it a bill for its impact?
- Do stakeholder relationships (with communities, customers, employees, the environment, suppliers, regulators) create opportunities or risks to the sustainable running of a business?
Every company creates “externalities” – costs or benefits that are not financially incurred or received by the company itself. I believe that the market will ultimately internalise these externalities, good or bad, created by companies’ activities in their valuations. I also believe companies with superior stakeholder relationships have franchises with greater longevity and should be able to generate consistently greater levels of profitability. Those that don’t nurture those relationships inject risk and volatility into their business.
One of the advantages of an integrated approach to sustainability is that it allows us to hunt in the more nuanced areas of the debate, which I believe will be richer from a returns point of view. This process is not about going long best in class and short the opposite. We believe companies have the potential to change, and through detailed work and engagement we can understand their potential and encourage change, or recognise where hopes are too high.
Why we use proprietary tools
Once you have decided the framework not just the output matters to you, as I have done, proprietary tools are the only answer. In the European Blend team we don’t use third parties to provide our target prices, so why would we use them to provide a sustainability score which could have a blunt effect on our detailed proprietary analysis? I believe that sustainability analysis can impact both forecasts and valuation multiples, and it therefore needs to be embedded through every step of our approach.
A unique combination of our Blend team fundamental analysts, our sustainability analysts and our in-house Data Insights Unit worked together to create two key proprietary tools designed to answer the two questions above.
One tool, SustainEx, helps us answer the question “Would society write a company a cheque or send a bill?” Using academic research, SustainEx allows us to estimate the extent of a company’s unrealised net impact on society from the externalities created by its activities.
Another tool, CONTEXT, helps us answer the question “Do stakeholder relationships create opportunities or risks?” CONTEXT allows us to rank companies against industry peers based on their behaviours towards key stakeholders using a combination of data and analyst insight.
Is there any role for exclusions?
Yes, having defended the key role of an integrated process, I also believe there is a role for exclusions born out of a consistent process. Within Blend we believe in the potential for companies to change. However, while this hope forms a key part of a sustainability process, in my opinion, it also needs to be tempered by the quantum of the challenge we face today and the concept of “do no serious harm”. As a team, we have exclusions based both on activities (SustainEx and revenues) and behaviours (CONTEXT).
We use hard exclusions on the long side of the portfolio to prevent us allocating capital to companies whose activities or behaviours have such a negative impact on society or their stakeholders that no amount of valuation support or potential for change can justify an investment.
On the short side, our approach is more nuanced and it is not simply the reverse of the long book. We have no exclusions based on activities or behaviour; however, our hunting ground is focused on companies with a negative impact on society and poor stakeholder scores.
Conclusion – this is just the start
The investment industry as a whole is still only at the start of its journey towards embedding sustainability in investment products, and even earlier in the world of long short investing. But I believe that when my children are investing they will not draw a distinction between sustainability analysis and fundamental analysis. Instead, the latter will have expanded to include the former.
Our dedicated sustainability tools help us do that now, and provide clients with options when it comes to both meeting their sustainability requirements and their risk/return objectives in both the long only and long short / absolute return markets.
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