Stockholm (HedgeNordic) – Thematic investing seeks to capitalize on significant secular trends in the economy or business climate, with sustainability themes increasingly becoming too important to ignore. Finnish asset manager Afalon Investment Management has launched a hedge fund that seeks to identify investments aligned with an array of sustainability themes.

“The investment approach evolves around the idea of sustainability,” says Jaakko Soini, the CIO of LS Fund – Incomea Steady Opportunities. “The secular trends related to sustainability and ESG will be the major investment themes going forward.” Soini currently follows six sustainability-linked areas, including ecologically-conscious fibers, plant-based food, cybersecurity, sustainable transportation, electrification and remote work technologies.

“The secular trends related to sustainability and ESG will be the major investment themes going forward.”

Soini seeks to build a more ESG-aligned portfolio by removing stocks with low ESG ratings from the entire universe of publicly-listed stocks. “The number of tradable companies in the Western hemisphere probably reaches about 40,000 companies,” says Soini. “By applying ESG and sustainability filtering, you probably still have roughly 10,000 companies to choose from,” he continues. “This pool will contain enough companies to pick and choose from.”

“By applying ESG and sustainability filtering, you probably still have roughly 10,000 companies to choose from. This pool will contain enough companies to pick and choose from.”

Structured as a UCITS fund, Incomea Steady Opportunities follows the concentration limits set down in the UCITS regulations. No more than four holdings will account for a maximum of 10 percent of the fund’s portfolio each, with the remaining 60 percent allocated across at least 12 holdings. “Since we follow six themes on average, UCITS regulations enable us to invest in two companies or more across each theme,” explains Soini.

Options Premium Collection on Dividend-Paying Stocks

The relatively concentrated portfolio is combined a premium collection strategy that involves buying short-dated out-of-the-money call options on its long holdings. This covered call strategy provides Incomea Steady Opportunities with a source of income in the form of options premiums while capping some of the upside potential from the underlying investments. “I use options on most names in the long portfolio,” says Soini. “Although I believe our long holdings will perform, I am willing to sell 5 percent or 10 percent short-dated out-of-the-money call options to collect premiums,” he continues. “If I were to sell call options on all the underlying shares I have, the delta of those options would be between 0.40 to 0.25, which means that delta-adjusted net exposure of the long portfolio would be between 60 percent and 75 percent.”

The covered call strategy fits well with Soini’s stock selection criteria that predominantly favors lower-risk/lower-reward high-dividend paying stocks. “On the equity selection, we mostly pick dividend paying companies that fit within our themes,” explains Soini. “This may sound too simple for an absolute return strategy, but our approach involves looking for companies that pay out dividends, for companies that are profitable enough to pay out dividends,” he continues. “In addition to providing us with an income stream, dividend paying companies generally do not trade at so high valuation multiples because of the stage in their business life cycle,” emphasizes Soini. “We do not want our portfolio to be prone to a decline in valuation multiples, so we do not have many holdings with high multiples.”

“On the equity selection, we mostly pick dividend paying companies that fit within our themes.”

Soini’s focus on dividend paying companies with low valuations implies a lower likelihood of sudden and sharp movements in the stock prices, which suits his covered options strategy. As long as the stock price remains below the strike price of an out-of-the-money call option through expiration, the option expires worthless and Incomea Steady Opportunities keeps the premium without running the risk of selling a stock for more than the current price. The use of call options also determines Soini’s investment horizon.

“My investment cycle rhymes in a two- to three-month period,” explains Soini. “We sell out-of-the-money call options for the long positions, so if a stock goes up over 10 percent until expiration two or three months out, I get to the re-evaluation window where I decide whether to buy right back and sell another set of 10 percent of out-of-the-money call options,” he adds. “The portfolio might turn at most four times per year, which happens if everything is called out. When options expire worthless and we get to keep the premiums, we might hold the stocks for an unidentified period of time. If we like the company, we can always buy back into it.” Soini also has the ability to hedge the portfolio using index futures in times of market turbulence, all with the aim of delivering absolute returns for investors.

From Pulp Fiction to Botanical Fibers in Fashion

One of Soini’s themes involves the transition from virgin cotton- and plastics-based fibers to sustainable fibers in the clothing industry. “The clothing industry is one of the most upselling markets in the world where people change clothing based on fashion, although some more than others, of course,” explains Soini. “And over 50 percent, in some cases up to 70 percent, of all the fabrics are made from fossil fuels-based non-recycled plastics. The rest is cotton, which requires a substantial amount of water,” he continues. “Consumers are increasingly demanding sustainable fibers and recycled, bio-degradable non-fossil fuel-based clothing. There are not many options available at the moment, but there are companies making fabrics out of botanical, cellulose fibers such as pulp.”

“Consumers are increasingly demanding sustainable fibers and recycled, bio-degradable non-fossil fuel-based clothing.”

Soini and his team follow Finnish listed company Spinnova and soon-to-be-listed Infinited Fiber as part of this theme. “Both companies have a solution to either produce fabrics from the recycled cotton mass or from botanical fibers,” says Soini. But both companies have yet to reach the point in the business cycle Soini is most interested in. “Infinited Fibers financials are similar to Spinnova’s, characterized by low turnover and large bottom-line losses, which is quite understandable at this stage of their journey.”

Austrian Lenzing, which produces and markets botanic cellulose fibers, appears to be a better fit for Incomea Steady Opportunities. “Lenzing has over 270 global brands in the fashion and clothing industry as its clients. The company has branded textile products available to consumer brands in Asia, Europe, and the Americas,” says Soini. “Lenzing is expected to have over 2 billion euros in sales, be profitable and pay a dividend for the year 2021. Fashion is a tricky business, but if you make fabrics in a sustainable non-fossil fuel-based way, you should be fine.”

This article features in HedgeNordic’s 2021 “ESG & Alternative Investments” publication.