While some hedge funds have been early adopters of sustainable investing, the industry’s advance has been incremental thus far. This is now changing as institutional investors demand the adoption of ESG into their investment process, the hedge fund industry recognises the potential for alpha generation through ESG factors, and regulators force their hands through new rules. The traditional risk–return equation is being rewritten to include ESG factors.

Sustainable investing can best be described as an evolutionary investment journey ABC: (A) avoid harm and mitigate ESG risks; (B) benefit all stakeholders; and (C) contribute solutions to societal problems. Institutional investors increasingly want their investments to do good socially and environmentally, plus promote high standards of governance and avoid reputational risk. They believe these factors are becoming material to investment returns, as our societies tackle environmental and social challenges such as climate change, water scarcity and loss of biodiversity. 

For their part, hedge fund managers are well placed to respond on account of their deep talent pool, technological capabilities, nimble investment strategies and activism track record. Their short-selling expertise has always been valued in encouraging investee companies to up their ESG game. But while this transition offers opportunities by promoting new ‘green’ industries, it is also fraught with fat-tailed far-off risks that are hard to model statistically, for lack of historical precedence. 

In our survey of hedge funds, 63% of respondents cited the lack of quality and consistent data on ESG factors as a key constraint, while 36% pointed to confusion over industry terminology. 

Nevertheless, some hedge fund managers take an opportunistic or inquisitive stance on ESG, believing data problems offer disguised opportunities to deliver alpha by exploiting the resulting market inefficiencies, possibly by employing machine learning and other quantitative solutions to better understand the market. And many institutional clients believe such inefficiencies will be a key source of alpha for hedge fund managers. 

On the opposite side are managers who are either sceptical about the available data or overwhelmed by the challenge of overcoming inconsistencies in data and company disclosures into their research and investment processes. They are cautious about making bets on strategies not tested by time or events over extended periods. 

ESG PENETRATION

Nevertheless, ESG is coming into the hedge fund space. Three approaches have been used by at least three in every 10 surveyed hedge fund managers, with many adopting more than one approach. The first one is ESG integration (52%), or identifying material factors and incorporating them into traditional investment processes, largely on a par with financial factors. 

The second approach is negative screening (50%), or excluding stocks that sit uncomfortably with the value system of investors. This approach has been the easiest one to implement. The third one is shareholder engagement (31%), which has been gaining traction lately as management teams have been slow to react to both ESG challenges and opportunities. 

Shareholder engagement is to serve two purposes: to enrich the investment process with first-hand knowledge about the investee company; and to steer the investee company into the ESG space via discussion, dialogue and proxy voting. For their part, investee companies need to have a clear ESG policy as well as mechanisms for monitoring outcomes.

The overall verdict when it comes to the performance outcomes of ESG-oriented investments is mixed. Twenty-nine percent of hedge fund managers and 11% of institutional investors in our surveys reported ‘positive’ outcomes, no hedge funds and 14% of investors reported negative outcomes, and while 71% and 75%, respectively, pointed to neither. 

The implied message is simple: it’s too soon to tell, given the rather short track record of these investments. However, managers who took an early lead are meeting performance expectations due to prime mover advantage and emerging as the ‘best in class’ across the entire investment spectrum.

This article was adapted from a longer report, based on two surveys. To read the full version, please click on this link.