The Biggest Opportunity in Markets Today is Pricing Sustainability in Real Time
Opportunity
We believe that the biggest opportunity in markets today is the pricing of sustainability in real time.
Sustainability arbitrage (“Susarb® ”) will, we believe, become the key investment strategy in the 21st century.
Mission
Our mission is to end climate change through sustainability arbitrage driving global adoption of Full Market Disclosure.
Susarb® uses our Full Market Disclosure innovation to generate sustainability price discovery so we can end climate change, biodiversity crises, and poverty.
Please see our November 29, 2021 piece ESG Data is a Public Good. Let’s Open It Up on Impact Alpha for more details. The article was republished on the Chartered Alternative Investment Analyst Association’s blog and on GreenBiz.com.
Partnerships
We want to partner with asset owners & managers to quickly scale our ideas up, because the best way for sustainability price discovery to work is if we have tens of thousands of capable, professional, regulated asset owners & managers using it overnight.
We believe that the world is ready for new ideas as the status quo is not working. We welcome your use and learning about your adaptations of Susarb®.
We can provide asset owners & managers:
Engagement with companies and institutional investors to initiate sustainability price discovery.
Guidance to put their entire portfolio online and update it transaction by transaction.
A detailed view of the Susarb® strategy as we understand it.
A solid solution for eliminating greenwashing risk.
Sustainability Arbitrage Strategy
(We think it’s best to explain a completely new idea by being as concrete and specific as possible - it avoids confusing generalities. Earlier this year, we wrote a version of the Susarb® strategy for trading US equities. This is presented below with light edits and additions. Institutional investors will easily see how they would adapt it to their strengths and investment style.)
Susarb® is a long-short strategy that initially focuses on two types of trades in large-cap US equities:
Reratings – profiting from the wild divergences between the various ESG ratings firms on the same company converging through a totally new activist approach to transparently pricing sustainability.
Flows – profiting from the erratic flows of capital on stock and bond prices driven by ESG ratings, data, indices, and ideas eventually converging to an appropriate pricing of sustainability.
Reratings
We will buy stocks in companies that our Sustainable Development Goals (“SDGs”) analysis (or you can use whatever method of stock selection that works for you) clearly indicates are good prospects (to limit downside risk and make an investment which we would expect would be profitable in and of itself), and then we will seek to add significantly more upside via clarifying its ESG rating, hence strengthening its investor base and lowering its funding cost, through:
Ideally working with an investee’s CEO, we will call up the CEO, portfolio manager, and the head of ESG at the company’s 20 largest institutional investors, educate them about Full Market Disclosure (“FMD”), and ask them to make their entire ESG analysis of the company a public good.
Once the company and the investors begin speaking to each other frankly about how the ESG analysis is being conducted (with a focus on hard, primary data), then genuine sustainability price discovery will start (which is the entire point of this exercise) and the company will be rerated, hopefully resulting in a profitable position. Futures, options, and equity short positions will be used to take market risk out, if needed.
The ESG industry behaves as if the company is the bad actor that finance has to police. But in truth, as opaque ESG data and black box ESG calculations have killed the market signal that generates sustainability price discovery, finance is a bad actor too. We believe that good companies have the best incentives to get their ESG right to tap green bonds and sustainable finance and to create an ardent following of ESG investors.
A trade example would be going long a water infrastructure stock with a wide range of ESG ratings based on our SDGs view that spending on water infrastructure will increase dramatically for a decade for a variety of factors. Working with the company’s CEO, we would reach out to the 20 largest institutional shareholders and explain the benefits of FMD and emphasize the benefits of sharing ESG analysis to really determine what the essential analysis is. After several iterations of updating ESG analyses and sharing it publicly, we believe that clear sustainability pricing will be positive for the stock and may at times lead to significant appreciation.
Flows
As markets orient themselves to a sustainable future, we’ll trade the impulsive tides of capital driven by ESG data and conventions through using our SDGs analysis (or whatever analysis you currently use – totally up to you) to assess an appropriate sustainability level given current factors. We will also trade the rich second order effects of Flows and Reratings ideas in this book too.
To aid the transition to a sustainable future by limiting the unnecessary destruction of capital, and as a dutiful adherent to the FMD ethic, we believe that it is important to state that “Market X, under conditions Y, are at an inflection price of Z.” Perhaps one benefit of public statements is that the Susarb® space will attract more capital from asset owners & managers as they recognize the positive informational impact of Susarb trades.
In fact, hedge funds can become impact funds by generating useful information. We see an immediate future where hedge fund performance will be increasingly valued on their thought leadership. By the way, this is nothing new in the hedge fund world. George Soros used to regularly do this on macro issues.
A trade example would be capital rushing into the solar panel sector following a change in government policy electing to extend tax credits for qualified middle- and low-income buyers. If our SDGs analysis strongly supported that this would be a one-off wave, we would get short the solar panel sector after the mania has had its run, and issue a statement that we see this as a temporary blip and are short the market.
Scaling Up the Strategy
Susarb’s strategy expansion could include mid-cap and small-cap equities, equities in other developed and developing markets, the whole gamut of fixed income, currencies, commodities, and other instruments.
But more importantly than just markets, Susarb® will evolve significantly such that firms will specialize in Susarbing specific kinds of industry and policy evolutions. As Marvin Minsky, founder of MIT’s AI lab, wrote in his seminal work “Society of Mind,” a complex agent-agency process will emerge.
Any Edge Can Be Used
We believe that this is where Susarb® gets really exciting as a strategy.
There are literally thousands of legitimate permutations to the Susarb® strategy, based on what is already working for you in the securities of the capital markets that you trade and invest in now.
We fully expect that as the information environment gets rich from a growing base of Full Market Disclosure investors, more granular specializations will develop as investors with exceptional expertise will focus on very narrow trades.
The SDGs (the U.N. Sustainable Development Goals)
Our edge underlying each Susarb trade is our well-developed, high-conviction SDGs views, which is quite important as we believe that most of the change in securities prices for now on will be driven by shifts in the global power dynamics of sustainability.
“Goal 17: International cooperation and implementation of the SDGs” is our SDGs research mantra because we have learned that by far the biggest surprises and opportunities in markets are the product of these drivers. Using this framework, we forecast paradigm changes such as the crude oil glut on September 15, 2019 (on the weekend when Saudi Arabia was attacked by drones), the covid crisis on February 12, 2020, the election of Joe Biden and its implications for markets on June 14, 2020, and the rally in China’s yuan on August 6, 2020. Each of these events were clearly seen before they occurred and had a significant impact, making them the ideal inflection points to trade and invest around. Another insightful piece is about how Mike Pompeo blew up the oil market, which set the stage for the current Ukraine crisis.
Perhaps our best call was our 2021 Surprise Forecast on December 14, 2020 for the Taliban to take over Afghanistan. Kelly Evans of CNBC covered it in a tweet writing, "This was so hard to predict" that this guy predicted it perfectly...back in December. "I believe that a significant surprise event likely to happen in 2021 will be the massacre by the Taliban of mid-level and low-level collaborators in Kabul." The fall of Kabul decimated the Biden presidency, and partnered Putin with Xi and the Gulf states, which may put our financial system in grave danger if utterly epic sanctions are implemented against Russia. Putin’s attack on Ukraine may spur China to attack Taiwan (creating a two-front war), which would crush US equities as the post-World War Two US world order would collapse.
SDGs analysis is crucial as the world will either become sustainable, or everything will collapse. The SDGs are the new macro.
Current Best Idea
At present, we’ve believed that Putin was likely to invade Ukraine to induce the US/EU/UK to unleash draconian sanctions which China and the Gulf states would ignore, creating a crisis in the US dollar as a reserve currency, and generating a huge rally in Chinese equities because its market is not correlated with the US due to China’s repressive Big Tech policies. This will be negative for US aligned equities and will hurt US hegemony, leading to higher US rates, which would generate a raft of significant short-term trading and long-term investment opportunities. It’s too early to be more specific than this.
Thoughts on Portfolio Construction and Risk Management
Our goal is to return 15% net each year, which we will likely exceed by not overtrading or taking excessive risk through having an achievable target. We will seek to make money when markets are good and keep monthly losses inside 3% with the goal of never having a double-digit monthly drawdown. We estimate that the portfolio may trade 5-8 major moves and 1-2 dozen minor moves in a normal year. We will focus on catching major market moves and will trade infrequently. The normal position of the portfolio will be mostly cash, excluding trades that become long-term investments driven by secular trends (and hedged when needed). Reratings and Flows trades should have a risk-to-reward ratio of at least 1-to-5, with sensible stops, and relatively short holding periods. We do not use a watch list but will trade a sub-portfolio of several hundred micro-positions (less than a tenth of a basis point) to develop and track ideas.
We believe that the best risk management happens in doing routine research well by enjoying one’s work, being low key, simple, and consistent, and focused on winning one point at a time.
Track Record
Because it hasn’t existed before, there is no track record or backtest of performance for Susarb® as a strategy.
However, we believe that over time value and growth will accrue to companies and instruments that align with what is obviously sustainable for the long-term. And those things which are NOT sustainable for the long-term will stop to grow and will eventually collapse in value.
The Winning Sustainability Strategy
Given the widespread agreement about the urgency to deal with climate change risks, the ESG business has developed a lot of interest but has so far failed to meet its promise by implementing solutions that generate the volume of transactions necessary to deliver change at scale.
The primary reasons for this disappointing outcome are poor data and unclear terms and standards. This can be remedied as we wrote in Impact Alpha:
“Standards like the Task Force on Climate-related Financial Disclosure (TCFD), Sustainability Accounting Standards Board (SASB), U.N. Principles for Responsible Investment (UNPRI), etc. would become applications that the Full Market Disclosure environment automatically tests and refines. Full Market Disclosure is a funnel that can efficiently process all of these competing applications. The more, the better!
They won’t be debated or promulgated – they’d be organically ratified by (Susarb®) use in real world investing, self-evident over time.”
The COP27 in Egypt is likely to follow the usual pattern of announcements, hurrahs, and disappointment, so let’s use the incredible power of the markets to price sustainability in real time through Full Market Disclosure – making sustainability a success.
Final Thought
Markets got us into this climate and biodiversity mess because they couldn’t price negative externalities – markets can get us out of it too with cutting edge innovation made possible by the latest technology and forward-thinking alternative investment professionals.