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Hedge Fund Managers Accelerate ESG Integration

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London (HedgeNordic) – Hedge fund managers are sometimes perceived as slow movers on the ESG front. For instance, a survey by investment consultants, bFinance, in April 2021 found that many investors interviewed viewed hedge funds as lacking a high degree of integration of ESG factors. The survey was however optimistically entitled “From Laggards to Leaders”, which hints at the rapid rate of change underway

Many hedge fund managers have been quietly running separately managed accounts catering for clients’ ESG preferences for some years, though they did not always make a lot of noise about the details for fear of sending a mixed message, and had not always formally documented all of their ESG policies. That is changing fast: a BNP Paribas survey found that the majority of hedge funds will integrate ESG by 2022, mainly due to client demand.

There is not always an easy “cookie cutter” template when applying ESG to various hedge fund strategies. The nuances of adapting ESG to different strategies can be partly addressed through a due diligence questionnaire (DDQ) available via several platforms: the The United Nations Principles for Responsible Investment (UNPRI); the Alternative Investment Management Association (AIMA); the Standards Board for Alternative Investments (SBAI), eVestment and DiligenceVault. To help with completing various DDQs and RFPs (requests for proposals), a growing number of hedge fund managers are developing formal and documented responsible investment policies and putting in place a governance framework for monitoring the policies.

There is not always an easy “cookie cutter” template when applying ESG to various hedge fund strategies.

The UNPRI has also published a paper on incorporating ESG into hedge funds. The UNPRI hedge fund advisory committee includes representatives from many hedge fund managers who have featured in HedgeNordic, including Brummer and Partners and Nordkinn Asset Management, in the Nordic region, as well as LGT Capital Partners, Macro Currency Group and Quantica Capital AG outside Scandinavia.

The report argues that, “governance has always been core to activist hedge funds which often take a more proactive and public stance than long-only managers on poorly governed businesses. A natural extension of this approach might be engagement on issues such as climate change,”. Indeed, one of the largest and longest established activists in London, Sir Christopher Hohn’s The Children’s Investment Fund (TCI), has launched an influential “Say on Climate” initiative, which asks companies for annual climate disclosures, climate transition action plans aligned with the Paris Agreement, and lets shareholders vote on these plans at Annual General Meetings. TCI’s Say on Climate resolutions have been supported by some of the world’s largest asset managers as well as proxy advisor firms such as ISS, which advise asset owners and asset managers on how to vote.

One example of why ESG needs to be tailored to strategies is that climate may be less relevant than other environmental issues for some industrial sectors. For instance, Sweden’s award-winning healthcare long/short manager, Rhenman and Partners, has identified water usage in countries with scarce water, as being an important area to monitor in drug manufacturing, where carbon footprints tend to be quite low. In other generally low carbon sectors, such as information technology and social media, ESG issues such as potential misuse of private data or workforce diversity, might be prioritised over carbon.

It is in some cases easier to apply ESG to equities than to corporate bonds – where there are usually no voting rights – though some corporate bond strategies do fit into one ESG framework, the EU SFDR (Sustainable Finance Disclosure Regime). For example, Norron, based in Sweden and Norway, is one manager that has designated its investment grade and high yield corporate bond strategies as article 8 under SFDR.

ESG is more commonly applied to any kind of company security than for macro markets such as equity indices, interest rates, government bonds, currencies and commodities, and adoption has so far been somewhat lower and slower for global macro and CTA strategies at the time of writing. Yet some systematic and quantitative CTA managers, such as Aspect Capital, have started using company-specific ESG data as part of their inputs. And CTAs such as TransTrend have been trading carbon emissions contracts for years, adding liquidity to these new markets. European carbon emissions, which have hit all time highs in late 2021, are most well known but there are also contracts in California and other regions on the US.

ESG is more commonly applied to any kind of company security than for macro markets such as equity indices, interest rates, government bonds, currencies and commodities, and adoption has so far been somewhat lower and slower for global macro and CTA strategies at the time of writing.

There are different opinions about how to use ESG equity indices. A growing number of ESG, low carbon and climate aligned equity indices exist, and they might well be used for performance benchmarking at least for long only strategies, or some long-biased hedge fund strategies. However, where index derivatives, such as futures or ETFs listed on CME Group, Eurex, or other exchanges, exist for such indices, they will currently tend to be much smaller and less liquid markets than traditional standard equity indices. There is therefore a potential conflict between the aspiration to use an ESG equity index derivative, and concerns about liquidity and transaction costs in these still nascent instruments.

The most ambitious ESG policies will apply beyond corporate securities to all asset classes. To this end, the PRI has published a paper on integrating ESG into sovereign debt, which includes assessments of factors including countries’ governance, corruption and rule of law; social progress on education and living standards and of course environmental quality in terms of climate and energy transition risk. There are also recommendations for controversial commodities such as palm oil and timber, and for ascertaining the provenance of metals and minerals based on OECD guidance.

Given the variety of different opinions and approaches around ESG, one approach is to offer clients a menu of customised ESG related options. For instance, one of Brummer’s Lynx’s programs, Lynx Dynamic, has excluded energy markets after discussions with key clients while other Lynx programs continue to trade energy.

ESG is most visibly associated with investment policies but it can also consider the company’s own firm policies. In principle ESG at the firm level should be similar for hedge fund managers and other asset managers, but in practice the small size of some hedge fund teams can require a pragmatic and flexible approach towards some typical ESG objectives. In terms of checks and balances, individuals inside the firm may be each wearing several hats, and functions such as risk management and compliance need to be at least partly outsourced for additional oversight.

ESG is most visibly associated with investment policies but it can also consider the company’s own firm policies.

If a hedge fund firm contains only two or three people, and a low level of assets, they might well use a third party management company. If they set up their own management firm, it could, at least initially, be unreasonably expensive to put in place a large board containing a majority of experienced and dedicated independent directors. And if the founders of a hedge fund are all white males, and there are only two of three of them, it is simply not possible to demonstrate a “diverse and inclusive” workforce in the way that larger firms can. Such small firms are often outsourcing many operational, compliance and other functions to a variety of service providers, so diversity measurements could arguably include the people working for their extended ecosystem, including their prime broker, administrator, custodian, auditor, legal adviser and so on.

 

This article features in HedgeNordic’s 2021 “ESG & Alternative Investments” publication.

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