(Bloomberg) -- The hedge-fund industry’s claim that short-selling is an effective way to do environmental, social and governance investing is questionable on several levels, according to MSCI Inc. 

There’s no proof that shorting a company with poor ESG metrics will raise its cost of capital, according to Rumi Mahmood, vice president of ESG and climate fund research at MSCI. What’s more, shorting is counterintuitive as a tool for aligning investor interests with good corporate conduct and may lack the kind of transparency that’s generally sought after in ESG investing, he said in an interview. 

It’s not a matter of “trying to be anti-hedge fund in saying this,” Mahmood said. “But it’s just the way ESG investing has evolved over the past few years.”

The hedge fund industry has lashed out against regulators for not explicitly recognizing short-selling as a valid ESG investment strategy. The London-based Alternative Investment Management Association has said European regulators have “definitely not” placed adequate focus on ESG shorting, while Cliff Asness of AQR Capital Management LLC has argued that shorting the “bad guys” is an effective way to ramp up their cost of capital.

Despite an absence of clear regulatory guidelines, some hedge fund managers have started claiming that their short bets on fossil fuel companies, for example, equate to negative carbon emissions. Lawyers representing the industry warn that the lack of clarity around accounting practices poses clear risks amid heightened concerns over greenwashing. 

Mahmood said that given the current “enhanced scrutiny on any and all ESG claims,” fund managers “will have to be more thoughtful.” That means being “able to back things up in an evidence-based manner.”

Mahmood said MSCI conducted its research in response to clear signs of confusion among market participants. The organization surveyed asset owners, asset managers and hedge funds, to find out how well ESG investing assumptions associated with shorting -- where investors make money when assets decline in value -- can be documented.

“If you’re going to say something like ‘our strategy as a result of shorting is raising these companies’ cost of capital,’ it wouldn’t be unreasonable to expect you to report or provide some evidence of that,” Mahmood said. 

But MSCI’s analysis “didn’t find any examples” of hedge funds reporting “to what degree they raised the cost of capital to any of their short positions,” he said. 

In fact, MSCI’s research found clearer evidence that a strategy of engagement, over time, is more likely to influence a company’s behavior than short-selling. Part of the problem, according to Mahmood, is the lack of obvious alignment between shorting bad ESG stocks and the goal of better corporate conduct. That’s because an investor who shorts a stock loses money if that company suddenly improves its performance.

There’s a “counter-intuitiveness” to it, Mahmood said. If a stock rallies because its ESG metrics improve, “your short position is destroyed.” The logic of a successful short bet requires a company to either stay “as bad as it is or become worse,” he said. If it improves, “that actually has an adverse impact on financial returns.”

And then there’s the question of how much real-world good an ESG short actually does. Mahmood said there’s a case to be made for using short positions to offset ESG price risks, but the strategy is essentially bogus as a tool for reducing carbon emissions.

“If you want to net off carbon price risks between your long and short, that’s completely fine, you can have a net zero carbon price risk portfolio,” he said. “But the key point is that mitigation of economic exposure to carbon emissions is not the same as mitigation of real-world emissions.”

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