How to Hedge Your Portfolio for Climate Risk
It could help to look at the trades of fund managers who have experienced extreme weather.
- By
- February 27, 2025
- CBR - Finance
As catastrophic wildfires, hurricanes, and floods roil the planet, investors are increasingly interested in portfolios to hedge the risks associated with climate change. A research team including Chicago Booth’s Julia Selgrad introduces a new methodology for doing so—one built on observing how fund managers react after experiencing extreme weather in their own neighborhoods.
The researchers—who also include Palantir Technology’s Georgij Alekseev, Yale University’s Stefano Giglio, Quinn Maingi from University of Southern California at Marshall, and New York University’s Johannes Stroebel—approach the challenge of hedging in reverse, by starting with beliefs. When investors decide to buy or sell stocks because of climate change, the issue must be on their minds—why? It could be because climate is in the news, but it also could be because of personal experience with changing weather patterns.
While climate change is a global problem, it’s also one that people tend to feel intimately. Booth’s Jane L. Risen and University of California at Berkeley’s Clayton Critcher find that when people feel warmer, they are more likely to believe in global warming. (Read more in “Sensing Global Warming.”) So fund managers who live through a heat wave should be more likely to believe climate change is happening, which could drive their decisions.
The researchers analyzed mutual fund managers, excluding ones with a focus on environmental, social, and governance issues or any particular sector. Mutual funds have to publicly report portfolio holdings each quarter, and regulatory filings indicate the physical locations of the fund advisers. The researchers then collected data about extreme heat events between 2010 and 2019, identifying three shocks that could lead people in the area to update their beliefs about climate change: deaths and injuries due to heat, crop indemnity payments (made to farmers who experience weather-related losses), and unusual weather relative to historical patterns.
How to construct a quantity-based, climate-hedged portfolio
These factors made global warming more salient for many people. “The occurrence of these shocks in an area leads to increased Google searches for the term ‘climate change,’ providing evidence that these heat shocks indeed induce updates in climate beliefs,” write the researchers.
They also identified a fourth shock to beliefs: transition risk, or the risk stemming from government responses to climate change. They teased this out of climate risk–related disclosures in the mutual funds’ shareholder reports by looking for changes in language over time indicating shifting beliefs about how climate change and related regulation would affect the fund.
The researchers then examined funds’ trading activity to see what the managers bought and sold after experiencing any of these shocks. Among the findings: When fund managers experienced a climate shock, regardless of what kind, they tended to react consistently. For example, they tended to buy auto stocks, perhaps betting that automakers will profit from the shift to electric vehicles. They also bought shares of insurance companies (as the researchers write, “because, in a world with heightened climate risks, insurance companies may face increased profits due to higher demand”) and of companies that make semiconductors—the brains for solar panels and smart grids, among other products. On the other hand, they tended to sell real estate stocks tied to locations that could experience severe climate-change effects.
These observations informed a model for constructing portfolios that goes long on stocks that managers buy and short on those that they sell. The methodology measures the quantity of stocks traded, not prices, but the shift in demand should move prices when climate concerns broaden, the researchers write. Consider a theoretical heat wave in Portland, Oregon. Local concerns rise, causing fund managers in the region to buy more semiconductor stocks. That localized effect is too small to meaningfully move prices. However, if climate concerns widen based on intensified heat waves across the country or other factors, more investors will buy semiconductors, and prices will increase, the researchers argue.
They created portfolios informed by each of the four climate shocks they studied, individually and in combination. They then compared those to other hedging proposals that have been suggested in various projects by other researchers. Every iteration of the manager-informed model outperformed the others.
This approach could, in principle, be applied to more than climate change, the researchers write. The quantity-based method could be used to create hedge portfolios related to other macroeconomic concerns, such as unemployment or housing market shocks.
- Georgij Alekseev, Stefano Giglio, Quinn Maingi, Julia Selgrad, and Johannes Stroebel, “A Quantity-Based Approach to Constructing Climate Risk Hedge Portfolios,” Working paper, September 2024.
- Jane L. Risen and Clayton R. Critcher, “Visceral Fit: While in a Visceral State, Associated States of the World Seem More Likely,” Journal of Personality and Social Psychology, May 2011.
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