By Jack Inglis, CEO – AIMA: It’s hard to remember a time before ESG or to pinpoint exactly when it broke through into the mainstream narrative in financial markets. To borrow from Hemmingway, it seems to happen “gradually, then suddenly”. From AIMA’s perspective, ESG has been a focal point of our market research and events calendar for several years now and the topic has never failed to draw a crowd.

Despite the overwhelming interest in ESG, the sector still has some fundamental wrinkles that must be ironed out to allow alternative investment market participants to buy into the movement completely. Chief among these concerns is the lack of consistent, comparable corporate data on which to base ESG assertions – noting the clear desire of firms to avoid “greenwashing” by misleading investors about their credentials. But change is coming as standard setters increasingly turn their attention to an overhaul of corporate reporting requirements, improving the ability of investment managers to develop products that prioritise ESG considerations and report against key ESG metrics.

The ESG regulatory landscape

In the EU, the Sustainable Finance Disclosure Regulation (SFDR) is the centrepiece of the bloc’s focus on sustainability and has made it a global leader in the race to tackle greenwashing and steer capital towards greener investments. It had a phase-one implementation in March 2021 and phase two will come into force in 2022, bringing additional requirements to boost transparency about the sustainability of the products that firms distribute. Moreover, its impact is being felt globally, given the fact that SFDR’s disclosure requirements capture not only firms based in the EU but also those who service EU investors.

In the US, the SEC recently created the Climate and ESG Task Force to study the issues surrounding this evolving investment area and is likely to pursue its own rulemaking – both at the level of corporate disclosure and the at the level of the information provided by investment managers to their investors. Regulators in APAC’s financial centres, such as Tokyo, Singapore, Hong Kong (SAR), and China are also pursuing green agendas.

What’s holding back ESG adoption?

Despite how much ESG dominates the financial narrative, and the sharp uptick of so-called ESG fund launches – many of which are seeing massive inflows – in the passive and active management spaces, there appears to still be a huge amount of headroom left for further growth.

In the wider alternative investment universe institutional investors, particularly pension funds, are understood to be driving demand for products and strategies tailored to their bespoke ESG policies, ranging from exclusion stock lists to bespoke strategies that fulfil their version of sustainable investing.

Investors are not only looking for a wider array of products, but they are also increasingly insisting that ESG criteria should be included in hedge funds’ investment strategies. Even though ESG-led investing is not new, hedge funds are taking an incremental approach, given the lack of consistent data and the expertise to interpret it, as well as disharmony over ESG investing rules in different jurisdictions.

Investors are not only looking for a wider array of products, but they are also increasingly insisting that ESG criteria should be included in hedge funds’ investment strategies.

A recently published report by AIMA and KPMG included a survey of 126 hedge funds representing approximately $1 trillion in AuM, found that almost a third (29%) believe it is difficult to develop ESG investment products owing to the different perspectives and definitions by investors and policymakers. In addition, 23%, the next largest segment, say they are still researching the comparative performance of ESG-focused versus traditional products. Some managers interviewed for the report described how investor sentiment varies around ESG scores or sustainability factors and that it is challenging to develop products until there is more specific clarity from the regulators on requirements. This may go some way to explaining why only 6% of respondents offer ESG products as part of their customisation initiatives.

In fact, in the same survey, when asked which of the various regulatory concerns present today will pose the most significant challenge to your firm over the next 12 months, conflicting multi-jurisdictional regulations was the most popular choice (28%), followed closely by ESG-related disclosure rules (26%).

The problem has been identified but solving it will require global cooperation among regulators and industry stakeholders to ensure any new rulesets serve to build confidence in the sector without stifling innovation. AIMA, for its part, is proactively engaging with rule makers to achieve this aim.

ESG in private markets

Elsewhere in the alternative investment universe, ESG has also already gained significant ground in the private markets. Our Financing the Economy research showed that most private credit managers now incorporate ESG into their investment process and that they are playing a key role in driving sustainability changes among small and mid-sized companies. ESG is also influencing loan documentation with covenants and coupons being redesigned to reflect sustainability linked KPIs.  This mixtures of carrots and sticks is becoming more prevalent in the market as private credit managers address their investors’ ESG needs.

Elsewhere in the alternative investment universe, ESG has also already gained significant ground in the private markets.

Private markets have come a long way in a short time and there are inevitably different views on what good looks like with respect to ESG and how to benchmark performance. 2022 is likely to see different initiatives converge to provide investors with a more consistent picture and one of AIMA’s priorities in the New Year will be to drive and co-ordinate this at an industry level.

What’s pushing ESG forward?

As mentioned above, the ESG sector is largely being driven forward by demand from investors, both institutional and retail, which is more than enough to sustain its trajectory while it works through its teething problems. A recent AIMA survey of hedge funds managing a combined $1.65 trillion asked hedge funds to list what was driving their interest in ESG investing, with 85% pointing to institutional investors, and 39% citing institutional consultants.

The ESG sector is largely being driven forward by demand from investors, both institutional and retail, which is more than enough to sustain its trajectory while it works through its teething problems.

Conversations with AIMA’s manager members this year also revealed that these investors are increasingly attaching ESG-related criteria to their allocations, even if the capital is not going towards a responsible investing strategy. Throughout the year, AIMA’s market research has found significant interest in ESG-related tools and products which will further lead many hedge funds to embrace responsible investing ethos in 2022 and beyond.

Beyond financial markets, the ESG agenda benefits from the major tailwinds of feeding into the global narrative around combatting climate change, which has significant political support and was encapsulated this year in the COP26 event in Glasgow.

What this means in practice is that the ESG sector will continue to thrive for the foreseeable future. But, for the sustainable investing movement to mature and move beyond the innovation phase, it requires solid foundations based on coherent and coordinated standards that will give investors and asset managers the confidence to step forward into the new, greener world before us.

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