Portfolio Strategy - Hedge Funds: Juggling the ESG imperative

Environmental, social and governance (ESG) considerations have become the biggest investment megatrend in decades, with the power to transform the nature and practice of capitalism. But with hundreds of ESG rating methodologies in the marketplace showing little if any correlation with each other, moving beyond lip-service and self-seeking ‘greenwashing’ can be a challenge for investment institutions. 

Hedge funds, which have a reputation for being among the most aggressive and sophisticated investors, cannot ignore the ESG megatrend, but deciding how to approach it is still best described as ‘work in progress’. Man Group, one of the world’s largest hedge funds, for example, has a diverse set of strategies across its divisions and therefore a range of different ESG efforts, according to Rob Furdak, CIO of ESG. With everything from futures trading to deep fundamental analysis and fund of funds, Man Group has many different philosophies and different approaches to ESG. “My role was meant to try to tie all of that together and to try to set a more central direction to our ESG efforts,” explains Furdak, who was appointed to the role in January 2020.

The speed and enthusiasm for embracing and incorporating ESG into investment strategies by both asset owners and asset managers has been uneven globally. According to Patrick Ghali, managing partner and co-founder of hedge fund adviser Sussex Partners, most of the interest seems to be coming from hedge funds in the UK and Europe, which makes sense given regulatory changes. But he finds it surprising that the US has been so slow on the uptake. Some foundations and endowments are showing interest, but US pension funds have interpreted pension legislation (ERISA) to mean they are not allowed to incorporate ESG considerations into their decision making. Instead, the view was that the focus had to be purely on maximising returns for beneficiaries. “Only recently have the rules been updated to allow them to take ESG criteria into consideration – that’s pretty crazy,” says Ghali. 

Late to the game

Furdak argues that hedge funds have been late to the ESG game as a result of the different timeframes of hedge funds and long-only investors. He explains that the average pension fund holds assets for 20 or 30 years, which lines up well with the timeframes for ESG factors to have an impact. Climate change, for example, unfolds over decades and centuries. 

By contrast, some hedge funds have very short time horizons. It does not make sense to incorporate ESG if securities are held for just a few days, or even hours or seconds. He adds: “So I think that you have to make sure that the way you’re incorporating ESG into your investment process is consistent with the investment philosophy.”  

Cliff Asness, chief executive officer at AQR, believes hedge funds can apply ESG consideration in long as well as short positions. On climate change, for example, he argues: “Shorting has impact by dissuading companies from pursuing whatever is objectionable to the short community in aggregate, in this case, carbon emissions.” Getting to net zero is close to impossible today with just long positions, but he argues investors could also “use a combination of both offsets and shorts to meaningfully lower emissions to get close to, if not achieve, net zero”.

Identifying sustainable strategies to take advantage of the ESG megatrend could be a source of outperformance for hedge funds. “The winners are going to be companies that have business models that align with the way markets think about the environment now, as against companies that have bad business models, but have very high valuations, just because they jumped on the ESG bandwagon,” says Ghali. 

Absence of standards

One of the biggest challenges is the lack of a unified standard to rate companies’ ESG credentials. “It’s very difficult to come up with great things you can rely on and then it gets even more difficult if you try and create a portfolio of funds, as each manager has a different way in which they report on ESG factors,” says Ghali. Sussex Partners has even found managers that call themselves ESG investors despite not having an ESG policy. 

Everything begins and ends with data when it comes to building a proprietary ESG model, according to Furdak. The big challenge, however, is that ESG data is a lot more subjective than financial, price or volume information. Taking one extreme view, he says: “There are a lot of ESG ratings which are not very highly correlated, so people say that this just shows that ESG ratings are rubbish and not really relevant to asset pricing.” 

“Shorting has impact by dissuading companies from pursuing whatever is objectionable to the short community in aggregate, in this case, carbon emissions” - Cliff Asness

Man Group, however, believes that different ESG ratings for the same company is a good thing as it indicates that each data provider is adding something to the story with a different perspective and metrics. Furdak says the key is to incorporate each data point in a framework that makes sense from a philosophical point of view. What matters then is not the final ESG ratings from each provider, but the data and analysis that went into providing those ratings. “You have to have a philosophy of what you care about – is it the impact of a product, sourcing of materials, energy use or the governance and oversight of the senior management?”

For Man Group it means giving portfolio managers the information they need to integrate ESG most effectively in the way they think about the world, says Furdak.

However, unlike other new sources of data, hedge funds cannot back test portfolio returns based on strategies incorporating ESG data and ratings over 10 or 20 years, because most of the data was not available until fairly recently. But Furdak argues: “No one’s hiring us to produce back-test results. People are only hiring us to generate returns going forward.” 

He says that when hedge funds put together their models and undertake research, they need to look not only at how historical ESG data relate to stock price and financial performance, but also try to have a philosophical view of how the ESG factors will add value – what is going to be the effect of an ESG policy? “If you have a more diverse, engaged workforce, is that going to lead to lower turnover and higher productivity which is going to increase profit margins?” 

For many investment firms these complexities increase the cost of analysis, whether at the stock or manager level. Ghali sees no choice but to rely on ESG advisers to help create an ESG framework within their investment process. But he says: “It would be much easier if there were some standards.”

Measuring success

It is likely to be some time before universally accepted standards are developed for ESG metrics. They are unlikely to be based on subjective ESG ratings, but rather on objective assessments of the total impacts of companies’ operations, products and services on the world and human well-being. In the meantime, ESG analysis can feed into risk assessments for investment decisions. As Furdak points out, the world generally seems committed to combatting global warming, which will create winners and losers. 

Traditional energy companies focusing on oil sands, for example, will be subject to tighter regulations and more potential for fines or lawsuits. Furdak says: “Those unexpected occurrences can influence prices and creates opportunities on both the long and the short side.” 

Measuring actual impacts in monetary terms provides early warnings of potential future risks, suggesting that impact data could potentially be a new factor for outperformance alongside value, momentum, quality and other traditional factors: “Impact is a good measure of success. When banks lend to underserved communities, or when pharmaceutical companies make their drugs available at low cost to poor communities, both of those things have massive positive impacts. But how do you compare the relative success of the two?” The measure of success has to be expanded beyond purely profits to shareholders to encompass added value to all stakeholders.

It is not just environmental concerns, though, that matter for hedge fund managers. “The culture of a company is hard to measure but a bad social issue can manifest pretty quickly in the stock price,” says Furdak. Video-game company Activision Blizzard is a case in point. Its share price collapsed after a lawsuit against it in mid-2021 by California’s Department of Fair Employment and Housing citing “numerous complaints about unlawful harassment, discrimination, and retaliation”. 

Orderly transition

In the long term, Ghali believes that any distinctions between ESG and non-ESG investments will disappear. “ESG is just going to get completely integrated into everybody’s process and it’s just going to be a part of what you do as an investment manager.” 

But if ESG investing is to become the norm, the transition – at least on the environmental side – must happen in an orderly way, argues Furdak. “If it doesn’t, we get what we saw in Europe in late 2021 with investors divesting too quickly from traditional fossil-fuel power generation, leading to massive spikes in electricity rates and massive spikes in energy prices.” 

The varying speeds at which the transition to sustainability in investment objectives is taking place create opportunities. There are passionate and disparate views on strategies such as the need to disinvest from oil and gas companies. But with no alternatives for air and sea transportation, in particular, demand will remain, perhaps for decades.

Not surprisingly, some hedge funds, such as Crispin Odey’s in mid-2021, were betting against what were perceived as overpriced renewable-energy companies and investing in oil companies that some pension funds had divested. Divestment is a controversial approach if the objective is to force companies to become more sustainable. Man Group’s view is that divestment is not the best way to make the world a better place for both companies and for the population. 

Furdak says: “You’ve got to change corporate behaviour and you have to do it in a way that tries to keep all constituents happy. We’ve got huge supply chain issues and if we say all freighters can no longer use fossil fuel, that would have massive impacts on the global economy, which will not make the world a better place.” 

For hedge funds, the transition to a world of purely ESG investments offers huge scope for innovative investment strategies. But those that rely on knee-jerk reactions and “greenwashing” are unlikely to show long-term outperformance.