Hedge fund options bets may predict green equities performance

If you want to know how your green stock portfolio is likely to perform next quarter, you should take a look at hedge funds’ options bets.

That’s according to a newly published academic paper which looks at a decade’s worth of data from more than 1,900 hedge fund firms through 2022. 

A key finding of the study is that the buildup of hedge fund managers’ put and call options on a given green equity can be used to “predict the stock’s future returns,” George Aragon, a professor at Arizona State University and a co-author of the paper, said in an interview. 

The analysis feeds into a wider debate around green investing strategies, which have delivered mixed results in recent years. The S&P Global Clean Energy Index fell more than 20% last year as the impact of higher interest rates pummeled capital-intensive green projects. This year, it’s down another 12%. The S&P 500, by comparison, has gained about 30% since the beginning of 2023.

High-profile Republicans have seized on such data to attack green investing as a dereliction of a portfolio manager’s fiduciary duty, leading to legal threats and outright bans on the wider environmental, social and governance investing movement. Meanwhile, hedge fund managers are increasingly incorporating ESG metrics in their investments, according to research by analysts at UBS Group AG.

Against that backdrop, the hedge fund industry’s approach to green investing is of particular interest. The authors of the paper, titled Are Hedge Funds Exploiting Climate Concerns?, posit that hedge funds have no “nonpecuniary preferences,” meaning their green bets are only made with a fiduciary goal in mind.

The study found that hedge funds are generally better than the wider market at predicting changes in sentiment and pricing around green stocks, and of taking advantage of those shifts. For example, when the general level of interest in climate change slips — gauged by looking at the number of news stories on climate — hedge funds use put options to sell at pre-agreed prices as green stocks decline in value.

Conversely, when there’s a higher level of general interest in climate change, hedge funds use call options to buy at pre-agreed prices in a rising market.

Aragon, who didn’t single out individual hedge funds, said the findings suggest that investment managers using the strategy are consistently “more skilled at reading green sentiment and predicting how it translates to prices around green stocks, and then using sophisticated instruments like options to make bets.”

For other investors looking to use this information to help support their own strategies, the clue is in the concentration of options, Aragon said. 

An increase in the proportion of hedge funds holding put options on green stocks from zero to 10% would predict an almost 17% decline in the stock’s price in the following quarter, he said. The price move is benchmark-adjusted, meaning it measures the excess decline versus other stocks with similar characteristics.

Conversely, an increase in the proportion of hedge funds holding call options on green stocks from zero to 10% would predict a benchmark-adjusted increase in the stock’s price of close to 6% over the following quarter. 

The team of academics behind the research, which also includes Yuxiang Jiang of Southwestern University of Finance and Economics, Juha Joenvaara of Aalto University and Cristian Tiu of University at Buffalo, measured climate concern based on newsflow stemming from major US news media.

The academics also explored a few other theses to gauge how hedge funds approach green investing strategies. 

One involved an analysis of how well hedge funds do with long-only green equity stakes, to see whether they’re simply better at picking the right stocks. By constructing “copycat portfolios” of stocks held by hedge funds (based on the funds’ regulatory so-called 13F filings), the researchers were able to compare how these performed against equivalent portfolios reflecting the holdings of brown hedge funds (defined as funds that historically have earned lower returns when green stocks do well). They also compared their results to a market portfolio of green stocks.

The researchers found that the green copycat portfolio’s outperformance versus the market portfolio was “marginally significant” at 1%, Aragon said. 

However, held up against the brown portfolio, the outperformance was over 5%, he said.

What’s more, hedge funds identified by the researchers as green — based on an analysis of their returns rather than client-facing labels or marketing — outperformed brown hedge funds by 7% on an annual basis, Aragon said.

“The evidence suggests that certain hedge funds generate alpha from investors’ climate concerns,” he said.

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