We present a simple dynamic investment strategy that allows long-term passive investors to hedge climate risk without sacrificing financial returns. We illustrate how the tracking error can be virtually eliminated even for a low-carbon index with 50% less carbon footprint than its benchmark. By investing in such a decarbonized index, investors in effect are holding a “free option on carbon.” As long as climate change mitigation actions are pending, the low-carbon index obtains the same return as the benchmark index; but once carbon dioxide emissions are priced, or expected to be priced, the low-carbon index should start to outperform the benchmark.

By: Mats Andersson is CEO of AP4, Stockholm, Patrick Bolton is the Barbara and David Zalaznick Professor of Business at Columbia University, New York City, and Frédéric Samama, deputy global head of institutional clients at Amundi Asset Management, Paris.

Read the full article in Financial Analysts Journal May/June 2016, Volume 72 Issue 3, here