Steven Desmyter writes, in Fundfire, about the key role that hedge funds will play in the growing world of ESG investment.
This article originally appeared in FundFire on 22 April 2020.
As the world is gripped by the urgent coronavirus crisis, it seems an opportune moment to take a step back and ask if environmental, social and governance (‘ESG’) investment really has a place within hedge fund portfolios.
Hedge funds have so far been on the sidelines of ESG investing, with managers calling up a raft of different excuses – from a lack of clarity surrounding data to the preponderance of greenwashing – to explain their unwillingness to build out ESG-focused investment strategies. Many in the sector appear to view ESG as, at best, a risk-management tool to help hedge distant tail events and, at worst, a fad driven by journalists and hippies that has no place in the cut and thrust of financial markets.
Meanwhile, hedge funds that have participated in the space have been subjected to criticism for using traditional strategies such as shorting to express their views on ESG-related themes, as if selling short the stock of an oil firm involved in a spill, or a bank caught up in an accounting scandal, was somehow tarring the hedge fund with the same brush. This anti-hedge fund bias tends to rear its head every so often, but we believe that this misses an important lesson about the place of our industry in a globalized economy: smart, information-driven investment firms bring clarity and sophistication to the markets in which they work. Hedge funds ought to be central players in delivering ESG to the wider marketplace.
While these are still early days, it would appear that stocks that score highly on ESG-related factors have outperformed their peers during the coronavirus-related volatility of recent weeks. It’s clear to us at Man Group that well-run corporations tend to take ESG seriously, and it suggests management teams with an eye on the future rather than fighting near-term fires, so it shouldn’t come as a surprise that these firms have weathered recent storms better than their peers. It’s also worth noting that while the ‘E’ of ESG tends to receive the lion’s share of coverage, social and governance issues have been thrust to the fore as we learn to invest in a world that has been reshaped by the coronavirus. To a certain extent, hedge funds will eventually be forced to engage with ESG whether they like it or not. But I believe that our industry ought to be pursuing opportunities in the space more actively.
Hedge funds, and particularly quantitative funds, ought to like messy data. A recent report by AIMA and KPMG found that 85% of hedge funds have made little or no effort to incorporate ESG data into their investment processes, with 63% of those surveyed citing the lack of quality in the underlying data as the reason for their reluctance. We believe that instead of being a problem, this looks like an opportunity.
There is only a 60% correlation between the ratings of leading ESG data vendors, compared with 99% for credit ratings. This lack of consistency between vendors allows the potential for arbitrage by those hedge funds able to judge which data sources to trust. We are still in the early days of ESG investment, but this factor will not develop further unless it is subjected to the rigors of scrutiny.
Allowing hedge funds to express views on a factor is a very good way of proving its worth. We can either treat ESG with kid gloves, letting it remain somehow removed from the real world of 21st century investment, or we can engage fully with it as a factor, calling out the charlatans and championing the steadfast. There’s nothing that will persuade our hedge fund peers to embrace ESG like seeing those who have been early adopters in the space making money there.
When we return to something like normality after the coronavirus crisis abates, we believe that there will be a heightened appreciation of our need – as a global society, and as market participants – to act to prevent crises of the future. The hedge fund industry, which has so far been lukewarm when it comes to ESG investment, ought to be playing a central role in subjecting the opaque ratings, unverified statements, and airy virtue-signaling that are so prevalent in the space to the rigors of the market.
We believe there is compelling evidence that ESG factors are critical drivers of stock prices and that historical underperformance of the factor (highlighted in recent studies by Credit Suisse and the Pacific Research Institute) may not be a reflection of how the future will play out. We know what happens when ESG performance goes wrong, and we’re slowly learning to recognise what getting it right looks like. Management teams will increasingly need to be able to justify their words with actions, and investors ought to be able to express their belief or otherwise in the validity of firms’ commitment to their ESG targets. If this means shorting the stock of those who over-promise and under-deliver, so be it.
Hedge funds are not the enemy when it comes to ESG; rather we should be part of the solution.
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