How to Hedge Your Portfolio for Climate Risk
These factors made global warming more salient for many people. “The occurrence of these shocks in an area leads to increased Google searches for the term ‘climate change,’ providing evidence that these heat shocks indeed induce updates in climate beliefs,” write the researchers.
They also identified a fourth shock to beliefs: transition risk, or the risk stemming from government responses to climate change. They teased this out of climate risk–related disclosures in the mutual funds’ shareholder reports by looking for changes in language over time indicating shifting beliefs about how climate change and related regulation would affect the fund.
The researchers then examined funds’ trading activity to see what the managers bought and sold after experiencing any of these shocks. Among the findings: When fund managers experienced a climate shock, regardless of what kind, they tended to react consistently. For example, they tended to buy auto stocks, perhaps betting that automakers will profit from the shift to electric vehicles. They also bought shares of insurance companies (as the researchers write, “because, in a world with heightened climate risks, insurance companies may face increased profits due to higher demand”) and of companies that make semiconductors—the brains for solar panels and smart grids, among other products. On the other hand, they tended to sell real estate stocks tied to locations that could experience severe climate-change effects.
These observations informed a model for constructing portfolios that goes long on stocks that managers buy and short on those that they sell. The methodology measures the quantity of stocks traded, not prices, but the shift in demand should move prices when climate concerns broaden, the researchers write. Consider a theoretical heat wave in Portland, Oregon. Local concerns rise, causing fund managers in the region to buy more semiconductor stocks. That localized effect is too small to meaningfully move prices. However, if climate concerns widen based on intensified heat waves across the country or other factors, more investors will buy semiconductors, and prices will increase, the researchers argue.
They created portfolios informed by each of the four climate shocks they studied, individually and in combination. They then compared those to other hedging proposals that have been suggested in various projects by other researchers. Every iteration of the manager-informed model outperformed the others.
This approach could, in principle, be applied to more than climate change, the researchers write. The quantity-based method could be used to create hedge portfolios related to other macroeconomic concerns, such as unemployment or housing market shocks.