A Quantity-Based Approach to Constructing Climate Risk Hedge Portfolios

Key Takeaways

Traditional approaches for hedging climate risk based either on historical time-series data or economic reasoning deliver weak and unstable results.
A climate hedge portfolio that is long/short the industries targeted by mutual fund managers after a change in their climate beliefs outperforms the traditional hedging approaches.
This “wisdom of the crowd” approach uncovers new insights about sector exposures to climate risks. Stocks in the automotive and insurance sectors tend to perform well in response to negative climate news and can therefore serve as a hedge, while stocks in the retail, real estate and commercial & professional services sectors tend to perform worse.

Summary

Motivation.

Climate risk hedging strategies are becoming increasingly important for investors. However, there are few financial instruments available that can directly hedge against these complex risks, and historical stock prices may not contain enough information to estimate climate risk exposures. This paper introduces a new method to hedge climate risks by analyzing the trading patterns of mutual fund managers following a change in their beliefs on climate change. These patterns can be used to determine the most relevant industries to buy and sell to hedge against negative climate news shocks.

Methodology.

The authors identify two primary triggers for a climate belief shift: 1) an extreme heat event in the manager’s region, or 2) changes in climate-related discussions in the fund’s disclosure reports. Since these events are localized and only apply to a small subset of investors, they do not move stock prices. However, the quantity of stocks bought or sold by fund managers following these events contains information on how investor demand for assets in certain industries at the aggregate level shifts in response to heightened perceived climate risks. The authors quantify how fund managers respond to these events by analyzing the quarterly trading data of nearly 2,500 actively managed non-sector mutual funds in the U.S. between 2010 and 2019.

Findings.

Traditional climate hedging strategies based either on historical time-series data or economic reasoning, such as shorting companies vulnerable to stranded asset risks, are generally not correlated with negative climate news events, suggesting that climate risks are complex and difficult to hedge.
The long-short quantity-based climate hedge portfolios constructed by the authors outperform the traditional approaches to hedging climate risks.
This “wisdom of the crowd” approach uncovers new insights about sector exposures to climate risks. The long-short hedge portfolio is long stocks in the automotive, semiconductor, insurance, and energy sectors and short stocks in the commercial & professional services, real estate, and retail sectors.
Insurance stocks can surprisingly serve as a hedge to negative climate news, potentially due to expected increases in demand for insurance when climate risks are higher and the ability of insurers to reprice premiums annually.
Similarly, auto stocks can serve as a hedge to negative climate news, potentially due to increase in demand for EVs from households and firms hoping to reduce their carbon footprints.
A similar quantity-based approach can be applied to hedging other macro risks, such as unemployment or house price movements.

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