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ESG — No Hiding Behind the Hedges

Report: Systematic Strategies

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By Harold de Boer, Transtrend – A theme that is increasingly in the spotlight for Managed Futures strategies is ESG, which concerns whether and how managers take Environmental, Social and Governance factors into account in their investment process. We suppose most investors do not strive to violate human rights by contributing to poverty, hunger, slavery, and the like; they will rather aim to contribute to human prosperity and welfare. Nor will many investors strive to contribute to the destruction of our planet, including its biodiversity and climate, if only because such destruction would undermine their own prosperity. However, there seems to be a wide spectrum of approaches to dealing with these various thorny issues.

One end of this spectrum can be described — perhaps somewhat harshly phrased — as ‘passive hiding’. Investors on this end of the spectrum prefer not to be associated with any of these issues. They do not want to be questioned or pointed at, and they do not want to get the feeling that they have to excuse themselves. In essence, they prefer not to be seen with dirty hands. This approach is most efficiently implemented by excluding all markets and instruments that are somehow linked to these thorny issues, preferably on the basis of ‘objective’ criteria formulated and quantified by an independent third party. The other end of the spectrum can be described as ‘active participation’. Investors on this side do not mind to get their hands dirty. They do not avoid thorny issues but rather discuss them, make their own decisions, and are willing to explain their choices. Even if doing so would sometimes reflect unfavorably on them.

From this, it may be clear that we at Transtrend are avid supporters of the latter approach. Not only because we believe this is the (only) way to have a positive impact, but also because we believe this to be in the best interest of our investments and therefore in the best interest of our clients. We are convinced that passivity in general does not deserve a reward and generally is not rewarded. When investors consider being seen with dirty hands a risk they want to avoid, they will pay a risk premium for that. We believe that the most rewarding way to deal with issues is to be part of the solution, not by shying away from them and most certainly not by closing your eyes to them. Successful investing in our view is about being on the road forwards, not about hiding behind the hedges.

At the same time, no matter our convictions, we have to be extremely modest. Taking our role seriously starts by acknowledging the limitations of our power. For instance, the fact that we predominantly trade futures contracts seriously limits the number of ways we can have impact. Carrying price risk, contributing to price discovery and offering liquidity — as important as these roles are for the well-functioning of markets — that’s about it. And we can only fulfill these roles if we in fact actively trade these contracts, not if we exclude them. So our (potential) impact starts with inclusion.

Active participation in the energy transition

There is a growing number of above all private investors — including those whose pensions are managed by pension fund managers — that prefer to invest fossil-free. While we understand this desire, we do not believe that making large scale fossil-free investments is currently possible. Our society is still highly dependent on fossils. Petroleum, for instance, is an important raw material for producing popular products like plastic and other synthetics, as well as petrol and kerosine. The use of fossil energy may have partly been replaced by the use of energy from sustainable sources such as wind and solar energy, but a lot of fossil fuels had to be burned for the manufacturing and installation of all the required wind turbines and solar panels. Not even Greta Thunberg can perform all her activities without the use of fossil fuels! Firms and investment managers might compensate for their use of fossil fuels, but that does not fundamentally change their dependency.

However, underlying this demand for fossil-free investments lies a strong force of people that endeavor to reduce our society’s dependence on fossil fuels and — driving this goal — want to reduce the emission of carbon and other greenhouse gasses. We embrace this trend, and we most definitely want to participate in it. The question here is: What would be effective ways to do so? We do not believe that reducing the ‘carbon footprint’ of an investment portfolio by selling (existing) stocks of high-pollution firms and buying those of low-pollution firms really contributes. In essence, this only changes the (potential) composition of the shareholder meetings of these firms. The voting rights of the stocks of the more polluting firms will move towards owners that care less about pollution. We do not expect that this will drive these firms to reduce their pollution. And, if instead of the actual stocks only futures and other derivatives on these stocks change hands, no one in the board room will notice any change. We do not shake up companies by trading derivatives.

But that does not prevent us from participating in such an important and far-reaching project as the energy transition — a transition that has a huge impact on many markets, not only those in the energy sector. For instance, large shifts in the sources of energy used induce large changes in the demand for various metals. Such changes constitute a major source of risk for many parties involved. For the parties that have to adapt their consumption patterns as well as for the parties that have to adapt their production process. For the producers of goods that will likely meet strongly growing demand as well as for the producers of the goods that likely will meet diminishing demand but that our society cannot yet do without. To keep the momentum of this transition going, someone has to carry these risks. This is foremost the role of investors. Futures contracts are extremely efficient instruments for transferring these risks. Therefore, if we want to participate in this transition in a meaningful way, if we want to fulfill our fundamental role as an investor, we have to trade the futures contracts that are directly or indirectly linked to this transition. That all starts with inclusion, not with exclusion.

By trading futures contracts we do not only carry price risk, but we also offer liquidity and contribute to price discovery. More generally, we contribute to the well-functioning of these markets. Which actually seems to be a reason for some investors to exclude some of these futures contracts. They do not want to contribute to the well-functioning of for instance the “dirty” coal market. The implicit assumption here is that a well-functioning market favors the polluting entities. But is this really the case? Just ask yourself which participants typically benefit the most from impaired markets. These are the participants that are best positioned to control the market. In the case of coal, these are the producers. If the coal market does not function well while our society cannot yet do without coal, the position of coal producers becomes somewhat comparable to that of drug dealers — their profit margins would be huge. We rather prefer that all legal, legitimate markets function well. Which among others is a necessary condition for environmental costs to be priced in properly. We certainly think there is room for improvement here. But we will not make an effective contribution if we exclude these markets.

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Harold de Boer
Harold de Boer
Harold is the architect of Transtrend’s Diversified Trend Program, responsible for R&D, portfolio management and trading. Harold was born and raised on a dairy farm in Drenthe. From a young age, he has been intrigued by linking mathematics to the real world around us. In the final phase of his studies, while working on the project that would later become Transtrend, he became fascinated by the concept of leptokurtosis — or ‘fat tails’ — in probability distributions, a topic which has inspired him throughout his career. Harold’s approach to markets is best described as a combination of a farmer’s common sense and mathematics, never losing sight of the underlying fundamentals

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