| Interview with Lukasz Pomorski, Managing Director and Head of ESG Research at AQR Capital Management
investESG.eu: What strategies do you see the most opportunity to pursue a dedicated ESG approach in, taking data challenges into consideration?
Lukasz Pomorski: “ESG investing has historically focused on traditional long only equity and fixed income strategies. These are still very important, but many allocators, consultants and managers have turned their attention to other strategy types, including private assets and, importantly, hedge fund-type strategies.
We believe that the hedge fund space is particularly attractive for ESG investors. It gives investors more tools to incorporate ESG-driven investment views, to hedge and manage ESG-related risks, and even to seek incremental impact when compared to what they could do in a traditional long-only strategy. We have been vocal proponents of utilizing hedge fund strategies that incorporate shorting in order to more strongly express ESG views for a number of years now (“Hit 2’Em Where It Hurts, ESG Investing 2.0”, “(Car)Bon Voyage: The Road to Low Carbon Investment Portfolios”and “Shorting your way to a greener tomorrow”), and we are glad that these points are increasingly discussed and accepted by industry initiatives, allocators, and other managers.”
In which area do you see the biggest data challenges?
Lukasz Pomorski: “Data is a common complaint in ESG circles. We may be the minority, but we believe the data is perhaps better than the common wisdom seems to hold. For example, you often hear that 3rd party ESG data is uncorrelated. That’s incorrect. If you choose two ESG providers at random, the correlation between their data is about 0.5, clearly positive. This is not as high as the correlation between credit ratings, but credit ratings serve as a poor comparison – they are much more uniform in methodology, whereas ESG scores from different providers are often very different in nature. For instance, some focus on headline risk, others focus on disclosure, and so on.
A better analogy would be to look at correlations between sell side earnings forecasts, which are also varied in their methodologies and have correlations closer to 0.5 than to 1.0. Most investors don’t think earnings forecasts are useless, and we believe the same view should hold true for ESG data.
In fact, we appreciate the diversity of views different stakeholders have on ESG, as it may help us better measure what a company’s ESG profile is, and it may even provide hints as to which companies may be mispriced in the market. We made this broad point a few years ago in a whitepaper.
That said, there are clear data weaknesses. For example, data on a company’s carbon exposure along its supply chain, known as “scope 3” emissions, is extremely noisy. Because of this, few allocators today use it in their portfolios, even if we all agree scope 3 emissions are a very important piece of the climate puzzle.
More broadly, the ESG data that is most useable for investments tends to be focused on outcomes – for example, does a company build products or services unambiguously linked to bad societal or environmental outcomes, like tobacco or cluster munitions, or does it produce externalities that affect the broader society or environment, such as greenhouse gas emissions? Unfortunately, much of the currently available ESG data from 3rd party vendors may be mostly focused on a company’s process and is often biased toward what companies say, rather than what they actually do.”
Please comment on the power of short selling as an ‘engagement strategy’?
Lukasz Pomorski: “There are two common misperceptions about engagement that serve as important context.
First, if the objective of an investor is to influence change in the real economy – commonly known as having impact – then the single best approach is to build an ownership stake through long positions. Then, an investor can utilize all the channels for impact that a long position enables, including proxy voting, direct engagement and getting a seat on the board.
Second, ESG investing suffers from a tradeoff: most ESG-sensitive investors are typically limited to tools with relatively little impact. This is because many investors are not prepared to own companies that are responsible for most of the ESG issues that they care about. Take climate – green portfolios hold companies with very low carbon emissions, making it impossible for the investor to vote or engage with the firms that are responsible for the vast majority of greenhouse gas emissions. Without incorporating these companies into the portfolio, it will be extremely difficult to meaningfully change economy-wide emissions.
This context allows us to discuss the power of short selling as an “engagement strategy.” Clearly, shorting does not allow for engagement in the same way as direct ownership would. However, it is more potent than divestment. Divestment has some impact by increasing the cost of capital for the underlying issuer, something one of our co-founders wrote about a few years ago. A short position can have incrementally more impact on cost of capital. Moreover, shorts receive significant attention from corporate management teams, which tend to be well aware of the overall short interest in their stock. This opens up a channel of indirect communication, potentially letting the corporate managers know that the short community sees problems with their corporate strategy. Such a channel is largely absent in divestment.”
Do you expect that – similar to carbon and CO2 – specific tradeable ESG market segments will develop in areas like biodiversity, water usage, human rights, etc.
Lukasz Pomorski: “Globally, climate is perhaps the most obvious element of ESG that investors currently prioritize. In our assessment, diversity and inclusion (D&I) is becoming the second most important element. In particular, this is evident among American investors, for whom it may often be the most important aspect of ESG. Other areas, such as biodiversity, water usage and human rights are all important, but perhaps are not yet as universally recognized as key issues. That said, there are a number of pan-industry initiatives around these issues, some led by the PRI, so we think it’s fair to expect more attention on them in the future.
We would also highlight the increased interest in portfolios reflecting various SDGs, or Sustainable Development Goals. This seems to be part of a broader movement to focus on investment outcomes – in this case, trying to measure what positive or negative impacts portfolio companies’ products may have on broader society and the environment.”
Do you expect that companies, asset managers and investors will be able to hedge climate risk and other ESG factors through performance swaps in the near future?
Lukasz Pomorski: “We believe so, and in fact AQR researchers coauthored one of the seminal papers in this space. We also have designed and launched strategies with this goal in mind.
It is a fascinating research question of how to hedge soft, long-term, and arguably systemic risks such as climate change. First, there is a measurement issue that we touched on above. There are no silver bullets here, and there is much to desired from commonly discussed measures, making this an attractive area for creative researchers to contribute to.
Second, climate risks are unlikely to be fully hedged in traditional strategies. Yes, we could build a long-only equity portfolio with a meaningfully lower carbon footprint than the benchmark, but all or almost all stocks have at least some climate risk exposure, so it will be impossible to build a diversified, core equity allocation that has no embedded climate risks.
An imperfect but perhaps useful analogy may be market risk. You can build a long-only equity portfolio with less market risk than the broad market – say, with a beta of 0.6 rather than 1.0 – but you will still have some residual exposure. However, if investors allow shorting, they may then build allocations that fully remove such risks. In our analogy, shorting allows you to build a zero-climate-beta portfolio. In fact, careful portfolio construction may actually flip the exposure from positive to negative, leading to a strategy that can be expected to do well when climate risks materialize. Such a strategy may be an attractive hedge for an allocator, effectively netting climate exposure the allocator has in a different mandate.”
Could you see countries or investors going long or short biodiversity and the opposite position in carbon to balance their overall ESG position? How would that work?
Lukasz Pomorski: “We would imagine that investors who care about one element will tend to care, or at least be neutral about, the other. So, they may not take an offsetting position per se, but rather optimize on one or both dimensions, without trying to take a negative position on the other one.
That said, assuming an investor wanted to maintain a neutral position on a broad ESG measure, the approach you describe will likely work. Improving the portfolio’s biodiversity exposure will likely improve the portfolio’s overall ESG score; shorting climate-oriented stocks will likely decrease it, and one could imagine balancing the two.
Incidentally, what you’re asking about is an interesting and rarely discussed feature of ESG scores: they involve implicit “exchange rates” of one ESG issue for another, effectively “pricing,” for example, how many tons of greenhouse gas emissions are equivalent to changing the board diversity of a given company.”
Any other comments you’d like to add?
Lukasz Pomorski: “Not at this point, but of course we are happy to continue the conversation if you have any further questions or if you’d like to follow up on any of the above.”
Thank you!
Sustainable investing is qualitative and subjective by nature. ESG investing can limit the investment opportunities available to a portfolio, such as the exclusion of certain securities or issuers for nonfinancial reasons. There can be no assurance that an investment strategy will be successful. AQR Capital Management is a global investment management firm, which may or may not apply similar investment techniques or methods of analysis as described herein. The views expressed here are those of the authors and not necessarily those of AQR.
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