Hedge fund paradox
Nina Röhrbein looks at how the few responsible hedge funds are reconciling their short-term outlook with the medium to long-term nature of ESG investing
For many responsible investors, integration of environmental, social and governance (ESG) criteria across the entire portfolio is the ultimate goal.
However, it seems that the more niche the asset class, the more restrictive the opportunities.
Research house Eurekahedge has only found 34 socially responsible hedge funds in its database. In fact, its analysts are sceptical - given the absolute return nature of the hedge fund industry - about whether responsible hedge funds will ever take off. Nevertheless, thanks to the growing awareness of ESG, the number of responsible hedge funds has risen in recent years.
“Traditionally the ESG focus was on equities,” says Michael Jantzi, CEO at Sustainalytics. “While we have seen an expansion of that focus to fixed income and emerging markets, until now it largely has by-passed hedge funds. With regard to alternatives, more attention has been paid to infrastructure, real estate and even microfinance, probably also because hedge funds is a catch-all phrase for a variety of different strategies.”
The term ‘responsible hedge funds’ in itself might already seem paradoxical to some. After all, while ESG investors are known for their long-term horizon, hedge funds are infamous for their supposed short-termism.
“ESG analysis has a medium to long-term horizon,” asserts Adam Seitchik, managing director at Auriel Capital. “But generating alpha in hedge funds requires more than simply long-term analysis because investors are looking for diversification and reduction in volatility and the challenge with long-term factors like ESG is, while they will add value over time, they could be fairly volatile in the meantime.”
“Responsible hedge funds almost seem like an oxymoron because investors typically approach the ESG space from a long perspective, wanting to invest in environmentally progressive products or infrastructure,” adds William Crerend, chief executive officer at EACM Advisors. “Hedge fund managers are generally perceived as hyperactive traders. While they are certainly more active than the typical long-only manager, the holding periods for many hedge fund managers, especially fundamentally driven ones, are longer than many investors imagine.”
Investors should not tar the entire hedge fund sector with the same brush because it comprises a number of different strategies. Some - such as long/short equity or M&A styles - are more suited to ESG than others.
“A long strategy is like any other and on the short side ESG analysis can highlight companies that may have a high risk exposure, which might be a nice added value provider,” says Jantzi. “Therefore ESG and hedge funds can go together quite nicely.”
However, derivatives hedge fund strategies or hedge funds that are focused on high frequency trading are too short-term to be a good fit.
With the exception of themed funds like clean technology funds, few responsible hedge funds appear to be around. Fund of hedge fund offerings seem to dominate the market.
Auriel Capital has one such fund. It was already offering absolute return hedge fund products when it developed an ESG augmented version in 2010, which it is now rolling out as a joint venture with Trillium Asset Management. It picks stocks based on valuation, profitability, shareholder focus, market sentiment and now ESG.
“We are establishing what Mercer calls the third generation of responsible investing, following the previous generations of negative and positive screening,” says Seitchik. “We undertake our ESG analysis by looking at the ESG aspects of each sector that are likely to affect risk and return in the medium, three to five-year, term. ESG is essentially one of five votes, a 20% weighting in stock selection, in determining whether a company is long or short in our process. What makes it third generation is that ESG can get outvoted or be supported by the other themes that are in the portfolio. It is, for example, possible for a mining company with poor ESG scores to end up in a long position on the back of its attractive financial characteristics, although, due to its ESG score, it will be a smaller position than it otherwise would have been.”
Nevertheless, Auriel also undertakes some screening in the portfolio, excluding stocks, such as tobacco and controversial weapons manufacturers, from both the long and the short side.
Harcourt Investment Consulting, which is part of the Swiss Vontobel Group, launched its socially responsible (SRI) fund of funds in November 2007. It focuses on hedge fund exposures expressed solely in sustainable instruments. As developing its own SRI policy was deemed too cumbersome, it co-operated with two major European asset owners, Folksam and Storebrand, took their two SRI policies and created a joint version based on them. The screening process resulting from this policy leads to an approved list of sustainable instruments.
New York-based Tower Capital, an equity long/short fund of funds, believes that equity long/short should be viewed as an equity strategy and the ESG tools applied to public equities should also be used. It also believes that most financial criteria have become commoditised and that sector-specific ESG criteria can provide an edge in generating alpha.
TerraVerde Capital Management, also based in New York, has been offering a multi-strategy funds of hedge funds focusing on renewable energy since 2009. It allocates capital to managers who execute a strategy that serves to reduce carbon footprint, which is broken down into two components - long-short equity and other. The long-short equity part includes managers who trade global equities of companies ranging from solar to water and power. The other portion of the portfolio contains arbitrage type strategies, such as weather, power and carbon trading.
EACM Advisors’ hedging strategy has a bias towards fundamentally driven managers who use leverage and are willing to operate to its baseline transparency level. Exclusions, engagement and positive screening depend on the individual hedge fund or fund of funds.
One of the biggest issues with hedge funds has been transparency. “There is no reason why hedge funds cannot be transparent and there is no reason why investors should not be demanding that transparency,” says Jantzi.
“Transparency is one of the biggest problems in the hedge fund industry, particularly for
institutional investors,” says Lawrence Doyle, the founding partner at Tower Capital. “If our long/short equity managers want to attract institutional capital they have to be willing to offer managed accounts which, in turn, provides us with full transparency on the underlying positions.”
Harcourt also uses managed accounts to monitor which instruments its hedge funds are exposed to.
EACM Advisors, says Crerend, only works with managers who have strong risk awareness and culture, understand the potential dangers of excessive leverage and have a reasonable level of information flow with their clients.
Erik Eidolf, managing director at Harcourt Nordic AB, attributes the small number of single SRI hedge funds to the complexities of SRI and hedge funds and the difficulty in combining both sets of skills.
He compares the setting up of an SRI fund of hedge funds to the chicken and egg problem. “You need to have some critical mass to get started because you have to convince good hedge funds to set up a managed account,” he says. “You also have to have a credible SRI policy.”
The financial crisis, many believe, has only accelerated demand for ESG and transparency in hedge funds.
But Seitchik says: “Bringing innovation to the market place now is much more challenging as investors are cautious about making allocations. We are finding the asset-raising to be more difficult than it was before the financial crisis.”