The author of this article considers the ways that hedge funds can and should put environmental, social and governance-focused approaches into action and make a robust return at the same time.

The letters “ESG”, standing for environmental, social and governance issues in investment, are now a familiar part of the wealth management lexicon. A continuing area of debate is whether ESG-driven investment ideas, such as those designed to protect the environment from harm and also generate returns, are as effective as other, perhaps more traditional, ways of managing assets. 

The hedge fund sector might not at first glance come across as a natural home for ESG-themed investment, but these funds, given their famed ability to make money by shorting and use their clout to force boardroom changes, should be part of the conversation. In this article, Keith O’Callaghan, chief investment officer and founder of New York/London-based firm FQS Capital Partners, considers the intersection of ESG investing and hedge funds. The editors of this news service are pleased to share these views; they don’t necessarily endorse all opinions of guest contributors and invite responses. Email tom.burroughes@wealthbriefing.com

2017 was a significant year for further integration of ESG into the hedge fund industry. ESG’s tectonic plates moved significantly laying the groundwork for great momentum in the future. ESG is a value creator, but this has sadly been overlooked by the industry, a result of the shifting political scene and focus on large regulatory changes (MiFID II, GDPR etc).

PRI
The United Nations Principle for Responsible Investment (PRI) launched its first foray into the hedge fund industry by publishing a due diligence questionnaire alongside Alternative Investment Management Association and Standards Board For Alternative Investments, which acts as a guide to assess a hedge fund’s commitment to responsible investing. 

The DDQ adds 14 questions in the areas of policy, governance, investment process and monitoring/reporting, which will shoehorn managers into addressing this aspect of their business and act as a filtering and comparison tool for investors. It is highly likely that reporting platforms like HFR and eVestment will start to incorporate this ESG information as a standard requirement for managers to complete.
Industry thought leaders

Prior to 2017, it was Nordic pension funds and peripheral industry voices that beat the ESG drum. Now, the opportunity set is clearer and more populated, with BlackRock naming ESG as the central investing theme for 2018, and BNP Paribas’ signature to the PRI marking the first global custodian to adopt international ESG standards. 

The near-term costs of ESG retrofitting are immense, and is often beyond the desire of larger firms and institutions to implement. Yet in the long-term, early ESG will present a more cost-effective solution.  Momentum to build in ESG to regulatory and corporate legislation will likely force these changes and the “green risks” of regulatory sanction, reputational damage and pecuniary fines are to be expected. 

Opportunities for the industry
ESG might be considered a fad, due to its inability over many years to gain tangible traction. However, we believe it is something that is now knocking at the door with both opportunities and threats. These threats relate primarily to regulation (momentum set by the French implementation of article 173 and the adoption of the 17 Sustainable Development Goals by 193 UN signatory countries) and being left behind by peers (most large asset managers and banks have some ESG product and implementation drive in place). 

The opportunities present substantial new waves of money looking to buy alpha that investors normally desire of hedge funds, but using a responsible investment ethos to select. We also see that the expensive retrofitting costs of ESG programs from large banks and firms is avoided by small firms. A smaller manager can relatively cheaply implement good ESG policies at the firm and fund level without compromising investment strategy and in due course it will be an assumed factor as much as regulatory compliance is today.

It should be noted that ESG cannot be a marketing pitch, it needs to be truly implemented, but of course the strategy must stand by itself as an offering without ESG. We see for example that the spread between non-Green and Green Bonds is not meaningful, an investment always needs to be a good investment, or said another way: irresponsibly investing in responsible investments is non-ESG compliant.

Putting strategy into action
There are two main routes for ESG fund compliance - systematic negative/positive universe screening with a layered negative qualitative discretionary filter or fundamental analysis with less binary negative/positive screening). From a hedge fund allocation point of view, the latter would be the more popular solution as it gives a lot of interpretive flex to the manager to define the investment universe.  We view ESG as evolutionary rather than revolutionary, therefore the change in cultural mind-set and processes is not a huge leap for most of the industry.

The industry has a lack of understanding and hence expertise of ESG and more problematically there is a lack of consistent definition of ESG as a concept. This is borne out through the diverse and differing thought pieces and research coming to market in the past few years and by the simple fact of incredibly low take up by hedge funds of even basic ESG positioning that could assist them in differentiating and fund raising. The other major hurdles we see for quick absorption of ESG into the industry relate to quality of data and perversely the requirements of ESG investors.
 

ESG and carbon data is available through MSCI, Trucost and Sustain Analytics amongst others. Issues arise however around consistency and reliability. We assume that data quality will improve (e.g. FTSE Russell Green Revenues solution) and we advocate strongly that a manager who depends on such third-party affirmations and data is acting reasonably. This data could allow managers to assess if their strategies (inadvertently or with small adjustments) could be presented as ESG compliant. However simple systematic screening in a vacuum will not in itself make a strategy of interest for an ESG investor in hedge funds.

Managers need to be forearmed when developing ESG solutions that they wish to distribute to ESG outcome focussed investors. Though ESG concept has been with us for aeons, it is still embryonic in the hedge fund industry, with few using it as a core principle for investment. Investors with an ESG outlook are looking at hedge funds to complement their portfolio, but an idiosyncratic attribute of this initial investor can be them being “believers” and desire the HF manager to believe as well. In time, ESG investors with a less binary view, will come when the industry normalises ESG as a standard pillar of operation, but initially a manager lazily packaging a product as ESG, will gain little traction. For example, awareness of the ability for cash rich “sinner” companies to game the ESG and Carbon rating systems and how you as a manager have safety nets built into the process to ensure a robust ESG compliant universe, will need to be answered in advance. Even more extreme, be aware that an investor may want a manager to adapt ESG across all funds, not just a single offering, the price of real belief.

ESG as a concept can be like punching mist in some cases and the minds of the industry need to gather to formulate agreed positions. It can be argued that G is already factored into standard investment research as is. Another view is that it is more appropriate separating ES from G. There are vast differences of opinion on whether shorting a sin stock is acceptable. 

One side argue that the downward pricing pressure forces other holders to reassess their interest in the stock. Others will say that the increased average daily volume created by the shorting can make the stock more effective as leverage collateral or bring it into the scope of HFT and other quantitative type manager models, where a high ADV input is a key component.

Conceptually the application of ESG factors, which are normally long term or asymmetric in nature (localised corporate black swan – Volkswagen scandal for example), do not integrate very well with the normal factor influences of hedge fund strategies, where generally holding periods are measured in milliseconds to several weeks. The G factor is likely the most material to such shorter term holding periods. We would however think that over time, the impact on capital flows by general ESG adoption by hedge funds on sin stocks will achieve the ethical goals of investors. 

This could affect sin stocks by way of more difficult and expensive access to capital markets, increasing haircuts for margining purposes, general reduction of average daily volume, all of which should have the effect of marginalizing the stock or forcing it to address ethical investor concerns. It is also the case that ESG scores contain asymmetric information content, they limit downside (fraud, fines) while leaving the upside intact - this is the less moral more pragmatic selling point.

Conclusion
As a firm we believe that ESG is worthy evolution for the industry. We have started to incorporate ESG more formally into our due diligence of the managers we invest in and will look at opportunities for ESG specific solutions and products in 2018 and onwards.

Managers who are willing to start incorporating ESG considerations into their firms and funds will give themselves an advantage over their peers and will anticipate structurally the inevitable regulatory strictures that are likely forthcoming.

A binary approach to ESG by ethical investors is counterproductive such as requiring all fund offerings of a manager to be ESG compliant. A gradual glide path to full ESG integration for the industry is a better approach. Ethical Investors should consider where Managers strategically plan their longer term ESG integration, utilise the best ESG data available to create their trading universe, address transparency requirements, have open dialogue and commit resources commensurate to their size. This carrot approach will we believe accelerate the industry and investors towards the desired ESG goals.