To insure against environmental risk, investors may construct a hedge portfolio. This is not easy to accomplish as there are no futures or options contracts with payoffs directly linked to the measurable effects of climate change, such rising sea levels or changing temperatures, particularly when looking at maturities spanning several decades.
An investor interested in hedging climate risk is thus faced with two options. One approach is to buy an insurance policy from a property and casualty insurer. This might be a useful option for insuring specific assets like real estate or equipment. However, for the typical investor, such insurance is unattractive, both because the available contracts are not general enough to serve as a broad climate hedge and because the contracts are highly illiquid.
Another approach is to form portfolios that synthetically hedge climate risk using existing assets that are not designed to be explicit climate hedges. This approach has the benefit that it is available to any individual with access to capital markets. The central challenge facing this portfolio approach to climate hedging is the difficulty of identifying assets that are exposed to climate change risk, as well as the exact nature of any exposure. For example, even though it might at first seem natural to suggest that oil stocks should underperform when climate change worsens, many traditional hydrocarbon firms have recently invested in renewable energies, which means they might even benefit from increased regulation such as a carbon tax in response to climate change.
In the current version of our Climate Risk Analysis, we present our performance analyses of existing environmental portfolios. These portfolios are ETFs and mutual funds that have been identified by Morningstar as having at least one of the following features:
For each mutual fund/ETF on the Climate Risk welcome page, we compute mean returns, volatility and the conventional Sharpe ratio over 1, 3, and 5 year periods and since inception. In addition, we present an exponentially weighted version which has about a 3 year half life but gives weight to events in the distant past. Assets can be sorted on any of these criteria.
The table also presents risk loadings on the market and on the Fama-French factors ( SMB and HML) estimated using the model below.Where is the portfolio rate of return, is the risk-free rate of return, is the return of the market portfolio, is the excess return of small cap stocks over large cap stocks, and is the excess return of high book-to-market stocks over low book-to-market stocks.
For additional information about the Fama-French model, see https://en.wikipedia.org/wiki/Fama-French_three-factor_model
By clicking on the name of a security on the Climate Risk welcome page, the user will be brought to a more detailed Climate Risk Analysis page corresponding to that security. We construct a portfolio consisting of a long position in the chosen security and a short position in SPY:US (SPDR S&P 500 Trust ETF). Users may select the time frame over which performance of the long-short portfolio and its constituents is displayed. The performance values are normalized to 100 at the beginning of the time period that has been selected. A plot of the fitted volatility series for the portfolio is also provided, which is computed using a GJR-GARCH(1,1) model.
At the bottom of the page, a listing of the top 10 constituents of the mutual fund/ ETF by net assets is provided, as well as the Fama-French factors for the fund/ETF computed using all available historical data.
We construct two additional portfolios whose performance can be compared to any of the long-short portfolios on the Climate Risk Analysis Page. The first of these, labeled SPY:US - XLE:US, consists of a long position in SPY:US (SPDR S&P 500 Trust ETF) and a short position in XLE:US (Energy Select Sector SPDR ETF). The second of these, called the Stranded Assets portfolio, was designed as a proxy for the World Wildlife Fund stranded asset return swap. This consists of a long position in SPY:US and a short position of 70% XLE:US and 30% KOL:US (VanEck Vectors Coal ETF).
Note that KOL:US was liquidated in late 2020. An equal-weighted average of the top 5 constituents of KOL:US are used post-liquidation.
Fama, Eugene F. and Kenneth R. French, 1992. The cross-section of expected stock returns. Jounral of Finance 47: 427-465. https://onlinelibrary.wiley.com/doi/full/10.1111/j.1540-6261.1992.tb04398.x
Fama, Eugene F. and Kenneth R. French, 1993. Common risk factors in the retuns on stocks and bonds. Journal of Finance 33: 3-56. https://www.sciencedirect.com/science/article/pii/0304405X93900235
Hale, Jon. 2017. "Climate-Aware Fund Investing." Morningstar Newsroom, February 17. http://news.morningstar.com/articlenet/article.aspx?id=745467
Hale, Jon. 2017. "Sustainable International-Stock Fund Options Are Growing." Morningstar Newsroom, July 20. http://news.morningstar.com/articlenet/article.aspx?id=816307