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ESG hedge funds: a contradiction in terms?

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ESG hedge fund sounds like an oxymoron. The goals of absolute returns and the ideals of sustainable investing appear to be in opposition – self-contradictory, even.

But that may be changing. A recent study by the Alternative Investment Management Association (From Niche to Mainstream: Responsible Investment and Hedge Funds) found that 40% of hedge fund managers surveyed were practising responsible investment, while half reported increased investor interest in ESG. Nonetheless, the extent to which this idiosyncratic sector of the asset management industry – which prides itself on investing in an unconstrained way to focus on alpha production – is ready and able to bring ESG considerations into its processes is up for debate.

But let us start by attempting to define our terms. One thing that hedge funds and ESG share is a lack of unequivocal classifications. There are almost as many meanings for hedge fund as there are descriptions of ESG investing.

The term hedge fund is itself problematic. Many now prefer to be known as liquid alternative or absolute return managers – a euphemistic response to the supposed bad reputation that hedge funds have in some quarters. But, for our purposes, hedge fund will suffice because they are funds or managers which hedge market, but also other, risks.  

The first hedge fund, started in the late 1940s in the US by Alfred Jones, was a partnership of sophisticated investors.

Today, the global hedge fund industry has $3trn (€2.6trn) in assets and thousands of investment managers practise a wide range of strategies covering the full gamut of asset classes. Managers continue to seek non-directional absolute returns with an emphasis on alpha over beta. They charge performance fees, often invest their own money in their funds, build concentrated portfolios, use specialist fundamental research to find idiosyncratic exposures or build sophisticated systematic models to trade markets. These include commodities through equities, credit, currencies and sovereign debt. They will often use derivatives, leverage and sophisticated instruments to affect their views. They focus on minimising loss, are performance driven and can seek niche, unrecognised opportunities. Importantly, managers prefer to be unconstrained by benchmarks or conventional thinking. They may have a bias to the shorter term and can be frequent traders; sometimes around a longer-term view or thesis.

ESG investing is similarly a cluster of ideas and approaches with common characteristics but no core definition. It has the aim of placing moral or ethical considerations (environmental, social and governance) in the investment process. Historically it was applied almost exclusively to the long-only equity markets. It consists of excluding stocks or sectors that are considered undesirable. 

stephen oxley

Currently there is more emphasis on the integration of ESG thinking into the investment process with less on exclusion lists of ‘sin stocks’. However, a surprising number of asset owners continue with the approach of excluding sectors, stocks or countries. Investment managers rely heavily on outside data providers and many complain about the lack of good data with which to make decisions. There are several difficulties including: a lack of consensus; poor reporting of data by companies; how to measure social impact; how to deal with conglomerates; and how to treat improving but imperfect companies. ESG indices may also embody non-ESG factor biases that could influence returns.

The debate about ESG’s impact on performance continues. Some speak of an acceptable ‘virtue discount’ – exchanging short-term underperformance for the longer-term good. Others highlight the concept of ‘ESG momentum’, where the sheer weight of money following ‘good’ companies will mean they will perform as they become the champions of the future. Performance data is contradictory and period-dependent but there is evidence and a coherent argument that, over the long term, ESG will outperform.

Where does that leave hedge funds, with their overriding need to produce compelling returns in the short term and their distaste for constraint?

I would argue that hedge fund managers have the mindset, tools and skills to make a significant contribution to ESG investing.  Hedge funds can provide an important diversifying complement to institutional portfolios. Now, late in a cycle, when equities are starting to become volatile as bond yields rise, it would be unfortunate if they are avoided because of ESG considerations. Hedge funds can also take ESG beyond long-only equity management to diversifying strategies and asset classes such as currencies, commodities, global macro, long-short credit, relative value, systematic trading and activist investing.

Hedge funds frequently combine long-term vision with a focus on specifics, are experts at pricing risk and identifying catalysts for change, have experience actively engaging with companies and the ability and skills to take short positions. Many are at the forefront of developing artificial intelligence as an investment management tool. This could help overcome the data problem in ESG – for example, by using techniques such as natural language processing to understand their true values and sustainability.

While some hedge fund approaches may be relatively easy to implement in the ESG context, others could be complex. Hedging could also present problems. Taking short positions (to profit when a security falls in value by borrowing it and then selling it) is at the heart of the hedge fund ethos. A simple ESG hedge fund strategy would go long ‘virtue’ and short ‘sin’. However, some institutional investors may have a policy of prohibiting short as well as long positions in excluded companies. This could be an unnecessary, if understandable, constraint.  

Not owning a stock or sector in an index – the traditional ESG approach – is effectively being short that exposure. Taking a physical short position helps amplify that view while reducing the portfolio’s market risk. Investors benefits by taking an active position in line with their long-term ethical view. Nonetheless, if a client insists, the manager can use a pre-screened ESG universe, possibly at the cost of some alpha.

Hedge fund firms are flexible and are sensitive to clients’ needs. The use of separate accounts can enable custom portfolios. These managers can help define ESG investment practices and develop new strategies using innovative techniques and instruments. Pension funds and other institutions will need to decide on the benefits of engaging with hedge fund managers for ESG. The managers will need to win their clients’ trust and confidence to show that they are not the contradiction in terms which they may appear. Instead they can represent a complementary alpha source to existing ESG strategies. 

Stephen Oxley is the vice-chairman of PAAMCO

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