(soft music)
Narrator: As catastrophic wildfires, hurricanes, and floods continue to devastate the planet, investors are increasingly seeking portfolios that hedge the risks of climate change. Chicago Booth’s Julia Selgrad and her coauthors developed a new methodology to address this need. Their approach uses insights into how fund managers adjust their strategies after experiencing extreme weather events in their own neighborhoods.
Julia Selgrad: So we were interested in finding out whether there was a way to hedge, i.e., insulate oneself against climate-change risk. And so this was motivated by the fact that there is a real lack of financial instruments out there that directly hedge climate-change risk. And so we were interested in finding whether there was a way to combine existing assets into a portfolio that performs well when there are negative realizations of climate-change risk, i.e., whether there was a way to construct a hedging portfolio that can insulate oneself from climate-change risk.
Narrator: The portfolio is built by analyzing the stocks that investors buy and sell following extreme localized weather events. The portfolio takes long positions in stocks that investors typically purchase after experiencing negative shocks to their climate-change beliefs and shorts positions in stocks they tend to sell during such events.
Julia Selgrad: So if everybody behaves the same way, i.e., everybody buys the same stocks when they experience a negative climate shock, and everybody shorts the same stocks when they experience a climate shock, then this portfolio will hedge aggregate risk, i.e., the price of the former stocks will go up and the price of the latter stocks will go down. And so one of the sectors that investors tended to buy when experiencing a negative shock to their beliefs regarding climate change is the auto sector. So we thought one reason why investors might go into the auto sector is because the auto sector is at the forefront of the green transition, and with electric vehicles playing a very important part in the plans to decarbonize the economy. And one industry that investors tended to sell when they experienced a negative shock to their climate beliefs was the real-estate sector. And we thought the reason why investors go out of the real-estate sector is because that sector is exposed to a whole slew of physical climate risk made worse by the fact that assets in the sector are immobile.
Narrator: To assess the hedging performance of the portfolio, the researchers examined how its returns aligned with the actual effects of climate change.
Julia Selgrad: And what we found was that there was a positive relationship between the returns of our portfolio and negative realizations of climate-change risk, which suggests that the portfolio indeed successfully hedges climate-change risk.
Narrator: The researchers then examined whether the method was also able to hedge other types of risks beyond climate-change risk.
Julia Selgrad: And so in the paper, we actually test whether this methodology also works at hedging macro risks like unemployment and house-price risk. And we actually find that it does, even though these macro risks are quite different in nature compared to climate risks.
Narrator: The method can be applied to any risk where shifts in investors’ beliefs and corresponding portfolio adjustments can be observed. (upbeat music)
