Long ESG, Short MCAP: Redefining Profitability Through Sustainable Investing

ESG (Environmental, Social, and Governance) investing is here to stay. It’s naive to believe otherwise. The world is facing the consequences of environmental degradation—wildfires, floods, and melting ice caps. Arctic currents are changing, and Arctic ice is disappearing. The looming disaster might not seem visible to everyone yet, but that's because we’re trapped in a “tragedy of the commons”—where short-term thinking prevails over long-term survival. People don’t realize the urgency because it hasn’t hit them hard enough. But make no mistake—it will hurt. And when it does, governments and regulators will have no choice but to enforce ESG measures with renewed vigor. Greta and the activists are coming back stronger.

Soon, not adhering to ESG principles may no longer be a simple choice; it could become an ethical mandate or even legally punishable. Consider a world where, if you’re an asset manager, you either adopt ESG or leave the profession entirely. This is no longer a distant possibility—it’s an approaching reality.

A Future Where ESG is the Only Choice

Let’s assume this scenario materializes. What options will be left for asset managers if ESG becomes the only acceptable investment framework? At that point, we would have no choice but to prove that ESG isn't just about saving the planet—it’s about creating wealth. For too long, ESG has been seen as a potential drag on returns, a “moral” investment approach that sacrifices financial performance for ethical considerations. But if ESG is to become the standard, we need to demonstrate that it can be a wealth generator, not a destroyer.

In essence, ESG must be about alpha generation—outperformance. If we can’t prove that ESG drives returns, the climate crisis will force us into sustainable investing simply as a survival mechanism. But wouldn’t it be better to proactively demonstrate that ESG works financially, instead of waiting for the impending climate catastrophe to dictate our investment choices?

Why the Market Struggles with ESG: The MCAP Problem

The real reason ESG adoption has been slow isn’t because the market doesn’t care about the environment or social responsibility—it’s because the market is focused on beating benchmarks, particularly MCAP (Market Capitalization)-weighted benchmarks. Investors want to outperform traditional indices like the S&P 500, and ESG strategies have yet to prove they can do so consistently. The market doesn’t have decades to wait for a BlackRock-style asset manager to create ESG-only indexes from scratch. We need a faster, more effective solution.

The only viable way forward is to prove that an ESG index can outperform its MCAP-based counterpart.

Creating a Winning ESG Index

Let’s take a practical example: suppose we use ESG scores to evaluate S&P 500 companies. We could screen out those with poor ESG scores, focus on the highest-quality companies with strong ESG credentials, and then sectorally replicate the S&P 500 while maintaining its capitalization structure. Essentially, we’re building a mini-S&P 500 of about 80 companies that are both high-quality and ESG-compliant.

This approach allows us to capture the core of the S&P 500, while filtering out companies that fail to meet ESG standards. Importantly, this portfolio would still reflect the size and sector balance of the broader index, maintaining its investability while offering an ESG-friendly alternative.

But the key question remains: Can this portfolio beat the S&P 500?

Beating the S&P 500 with ESG: A Smarter Strategy

We live in a world full of gatekeepers—regulatory bodies, institutional investors, and traditional market players—who hold the keys to the flow of capital. To break through these barriers and prove the value of ESG, we need more than academic theories. We need real-world performance that shows ESG can outperform the market. And to achieve that, we don’t just need innovation, we need to outthink the current market structure.

This is where the concept of “Long ESG, Short MCAP” comes in. Long-short strategies, while not new, have historically struggled to gain traction because they are complex, idiosyncratic, opaque, discretionary, and hence difficult to scale without the help of advanced algorithms or machines. Let’s assume a Long ESG 80-components portfolio and short SPY strategy could do just that—automate, run perpetually, be less idiosyncratic, simpler, and deliver annualized double-digit returns with limited drawdown and low risk. It would be compelling proof that ESG is profitable and that there is a possibility to create a strategy that aligns moral values with financial performance.

A Financial and Ethical Revolution: Long ESG, Short MCAP

This is not just a moonshot idea—it’s an inevitability. Machines of today are capable to do that. Conventional finance dismisses such an approach as impossible, but markets are the true judges of what works. Post a real money test, with a few visionary investors to back a Long ESG, Short MCAP strategy, we could spark a revolution in how ESG is perceived by the financial world.

Imagine a scenario where, after just a few years of robust performance, hedge funds would be the first to embrace it. Hedge funds love risk-weighted profit more than anything. Above 10% risk weighted return for a few years is a compelling high yield asset class. After the visionaries will come the early adopters, the larger players, open to automated investing. And then the floodgates would open as investors start pouring out of traditional MCAP ETFs, abandoning the MCAP majors like the SPY (the S&P 500 ETF) and moving towards the long side of ESG US 80 as they see both wealth and positive impact. Once that trend begins, there would be no turning back.

Innovation—real, measurable innovation—is the only way to solve the tragedy of the commons. With ESG at the forefront, driven by smart, machine-powered strategies, we can align financial incentives with the need for sustainability. By doing so, we not only secure a better climate for future generations but also tap into a new era of wealth generation that marries impact with returns.

A Long ESG, Short MCAP strategy is the innovation hack the world needs most. By proving that ESG doesn’t just protect the planet but also drives alpha, we can set the stage for a new kind of finance—one that is profitable, sustainable, and forward-thinking.

In this future, ESG is not just a niche for the ethically-minded; it’s the foundation of a wealth-generating, impact-driven financial system. This is the opportunity to align markets with the environment, and to build a world where making money and making a difference are one and the same.