Expectations around responsible investing are rising across the investment industry, but there remains little consensus on definitions and applications. We attempt to bring some structure to this debate as it applies to equity hedge funds.
Expectations around responsible investing are rising across the investment industry, but there remains little consensus on definitions and applications. We attempt to bring some structure to this debate as it applies to equity hedge funds.
September 2022
Managers’ beliefs about the merits of RI analysis in their investment process are wide-ranging.
Tom Stoppard’s play, Rosencrantz and Guildenstern Are Dead, explores minor characters from a much larger story. Managers of hedge funds focused on responsible investment (RI) may feel similarly overlooked and deserving of greater attention.
Estimates of the extent to which RI practices are incorporated in hedge-fund strategies vary, but most indicate that RI-focused managers are still very much in the minority. In 2019, as little as 29% of hedge-fund managers were reported to have even the bare minimum of an ESG policy in place.1 A year later, a survey found just 15% of hedge funds had integrated ESG in their investment strategies.2
Yet there are nuances beyond these headline numbers. Across the universe of equity hedge-fund strategies, managers’ beliefs about the merits of RI analysis in their investment process are wide-ranging. Even among those managers who do integrate RI analysis within their process, various approaches are used.
“Don’t you discriminate at all?” Guildenstern asks Rosencrantz in a moment of exasperation. At Man FRM, we seek to understand the differences in managers’ RI approaches. We conduct RI strategy evaluations as part of our manager underwriting process, with four categories of managers:
| RI Unaware |
Little or no integration of ESG factors or engagement in the investment process and decision making. |
| RI Aware |
Limited or sporadic ESG analysis and engagement in the investment process and decision making. May evaluate ESG but it does not impact decisions. |
| RI Integrated |
Established and documented integration of ESG analysis in the investment process. ESG analysis clearly impacts investment decision making. May have some level of engagement. |
| RI Dedicated |
Leader in the integration of ESG analysis and active engagement in its investment process. RI is the core thesis of the strategy, either as a thematic or impact offering. |
To place managers within one of these categories, our evaluation looks across three areas of assessment:
- Business-level support for RI
- Strategy-level ESG integration
- Execution and reporting of RI objectives
Spanning the range of the four manager categories, we have found key distinctions in how managers explicitly integrate ESG analysis in their investment process. In this paper, we aim to outline the trends we have found within the main categories in today’s marketplace. We focus specifically on long/short and event-driven equity managers, as in our view ESG integration is most developed in such strategies.
This report reflects what we have learned through our evaluations to date, based on extensive interviews both with managers to whom we allocate and their peers. However, we note that the industry is still early in the development of ESG analysis. The standard has not yet been set.
RI Aware
We start with the RI Aware category, as RI Unaware should be self-explanatory. It’s easy to identify the shortcomings of RI Aware managers. Formal ESG investment policies are unlikely to be in place; where they do exist, they tend only to be statements that outline high-level ESG awareness which we find more aspirational than purposeful, or to feature soft language on ESG such as “when we deem relevant”. Similarly, RI Aware managers may have one or many of the following characteristics: no dedicated ESG resources on the investment team, conduct little ESG-related engagement, do not measure or report on ESG impact, are not signatories or supporters of the PRI or any other sustainability initiatives, and ESG data are not formally integrated into the investment decision-making process.
While awareness of ESG risk factors generally shone through in our conversations with RI Aware managers, it was not evident in our examination of their policies or systems.
Unfortunately, while awareness of ESG risk factors generally shone through in our conversations with RI Aware managers, it was not evident in our examination of their policies or systems. This disparity was the most apparent differentiating factor between RI Aware and RI Integrated managers.
On the plus side, many RI Aware managers viewed ESG as a risk factor, maybe something that would deter them from investing, rather than a positive qualifier for an investment. In addition, on the event-driven side, we found existing governance structures in companies involved in a transaction to be an important consideration in terms of influence and impact on the probability that a deal may close and how minority shareholders are likely to be treated.
RI Aware Case Studies
Long/short Manager A integrates analysis of ESG factors as part of the investment process when appropriate. The manager may own ESG improvers and short decliners thematically. The manager has access to a wide team of ESG research analysts, quants, and shareholder engagement analysts. The PM stated that ESG was more of a “tool in their toolbelt than a fundamental part of their process”. The manager was better able to demonstrate the integration of ESG factors into their decision-making on shorts, seeking to use ESG issues to generate potential short alpha (on the basis that when the market identifies those issues, the company’s stock price will go down and the manager will profit from being short).
Event-driven Manager B’s investment team has discretion over how to apply ESG considerations in their investment process. As well as focusing on governance in merger arbitrage, environmental factors may be considered as a risk factor that may influence a deal (e.g. in mining or energy-related deals). The team does not currently actively use a proprietary ESG analytics tool developed by its wider organisation.
RI Integrated
RI Integrated managers, on the other hand, more actively strive to incorporate ESG into their investment process, and furthermore document it. This is reflected in their more robust ESG policies, employment of ESG-dedicated analysts (although this can depend on the size of the firm), use of third-party data (such as MSCI ESG Ratings, Sustainalytics, Bloomberg or Integrum ESG), and evidence of an ESG thesis in underwriting (although the rigour and quality of this varies). ESG reporting to clients was not particularly well established or systematised across the managers we interviewed, but bespoke analysis by request was observed. Negative exclusion lists are often applied but are far from universal; the most frequent exclusions are generally for fossil fuels, cluster and certain other types of munitions, with tobacco and UN Global Compact violators less-common exclusions.
The specifics of an RI Integrated approach depend on the nature of the exact strategy employed.
The specifics of an RI Integrated approach depend on the nature of the exact strategy employed, and we observed many differences across event-driven strategies. For example, while merger arbitrage is shorter dated and focused on a specific corporate transaction dynamic, more opportunistic special situations investing has a longer time horizon and a more complete palette of potential value drivers and paths to access them. While RI Integrated equity long/short managers rarely employ activism (albeit larger firms will generally participate in proxy voting), event-driven managers focus on catalysts for unlocking potential value and so it is typically in their best interests to engage target companies to achieve those goals. Examples we have seen include dialogues with firms on their positioning towards long-term carbon neutrality, and how related transparent disclosures (and ideally formal commitments) might add value from an ESG perspective.
RI Integrated Case Studies
Long/short Manager C uses ESG as one of many inputs into the investment process, consistently applying ESG analysis across the entire coverage universe. While ESG considerations do not drive investment decisions, their inclusion in the research process means stocks with identified ESG risks may receive a less positive overall ranking versus sector peers and thus are less likely to be considered as long investment ideas. The manager was able to describe their comprehensive ESG checklist, their quantitative ESG model (based on separate E, S, and G scores at the sub-industry level), and how the two are combined. They showed how analysts can override quantitative scores, with a requirement to provide rationale in the manager's proprietary equity research system.
Event-driven Manager D has an active sustainability overlay that overweights capital allocations to target companies that have higher ESG ratings (based on an independent industry resource). The manager also uses dynamic investment screens based on governance metrics and excludes bottom-decile ESG-rated securities, while static exclusions apply for certain problematic industries. Finally, the manager has sustainability-focused protocols for proxy voting.
The difference between a “best-in-class” policy for an RI Dedicated versus an RI Integrated manager usually comes down to the fact that the latter uses softer or less-binding language.
RI Dedicated
So, what elevates the RI Dedicated above the RI Integrated? At one level, it is simply clearer and firmer policies together with a more thorough application of ESG analysis. The difference between a “best-in-class” policy for an RI Dedicated versus an RI Integrated manager usually comes down to the fact that the latter uses softer or less-binding language (i.e. names in the portfolio did not always have to meet minimum ESG thresholds). A mission statement is often included in the policy, and specific sustainable development goals (SDGs) may be referenced.
This is furthermore embedded in the staff themselves. Rather than having discrete resources focused on ESG, the whole team is fully dedicated to RI. Ongoing training of employees takes place, such as through the “Advanced Responsible Investment Analysis” course from the PRI Academy. These managers are typically also UNPRI signatories, and in addition may be supporters or signatories of other sustainability initiatives (such as the Carbon Disclosure Project, UN Global Compact, SBAI Responsible Investing working group, or the NYU Stern Center for Sustainable Business). European managers may run SFDR Article 8 or 9 products; this is not a requirement for inclusion in this category but is common to see.
We also observe RI Dedicated managers differentiating themselves through less-intuitive methods. For example, exclusion lists are not comprehensively used. This is justified because ESG winners are inherently not going to be in the business of the most common exclusion list constituents, or because bottom-up investment selection processes ultimately focus on a relatively small number of well researched companies (and current shortcomings may be a source of opportunity for event-driven managers). Similarly, while RI Dedicated managers typically draw on ESG data from the likes of MSCI, Sustainalytics and Bloomberg, there is a greater reliance on internal evaluation and scoring processes based on proprietary frameworks as most of these managers acknowledged shortcomings in the third-party data (for instance, a stronger ratings bias to larger-capitalisation companies). Some managers looked to take advantage of this variance by shorting stocks that had strong third-party ESG ratings but where they were able to identify ESG issues through their own analysis and frameworks.
The emphasis on proprietary analysis is evident in RI Dedicated managers’ underwriting.
The emphasis on proprietary analysis is evident in RI Dedicated managers’ underwriting, where stock pickers are required to detail an ESG rationale for every company owned in the portfolio. Changes to the thesis should trigger buys after improvements, or sales after downgrades, with managers held accountable for adhering to this process. This is often clear in investment memos and/or committee minutes.
While almost any manager could adopt these practices, we also see that certain types of strategy lend themselves more easily to RI dedication. For example, RI Dedicated long/short managers largely run thematic strategies, where the investment philosophy companies that offer positive (for the long side) or negative (for the short side) ways to play ESG themes. Thematically, these managers have to date tended to concentrate on the environmental and social aspects of ESG, as this is where most of the SDGs are focused. Governance is often already included in fundamental analysis, however, generally as a risk tool – i.e. taking longs in companies with strong management teams or boards, and shorts in those companies with perceived weaknesses in those areas.
In the event-driven space, RI Dedicated managers are typically activists. These managers either pursue dedicated impact strategies, or more generally focus on active engagement strategies seeking to increase shareholder value (such as by closing perceived discounts to intrinsic value), with ESG considerations a key thesis. Common to these managers is the principle that the ESG profile of target companies can be improved through active engagement, which also means avoiding simplistic or binary exclusion strategies. Like in long/short equity, traditionally activist managers primarily focus on corporate governance and related strategic and operating inefficiencies. These managers tend to adhere to long-term holding approaches. Activist strategies understandably run fairly concentrated portfolios with medium- to long-term holding periods, which is also reflected in longer lockups for investors.
Proxy voting is a common way of actively engaging with companies. Managers generally have proprietary frameworks to implement proxy voting but may also consult external resources such as Glass Lewis. However, not all event-driven managers pursue activist strategies and this is not currently a requirement for inclusion in our RI Dedicated category.
RI Dedicated Case Studies
Long/short Manager E has defined investment themes aligned to SDGs which guide the idea-generation process. Examples of such themes include creating a sustainable food system, enabling environmental solutions, and healthy and productive living. Within each theme, the manager seeks to own companies throughout the supply chain that are delivering solutions to societal and environmental problems. Conversely, shorts are generally bad actors or incumbents which are being displaced by these solutions. The manager may – but is not required to – engage with portfolio companies.
Event-driven Manager F runs an activist strategy aimed at listed large-caps. Their approach fully integrates ESG into their investment process, also using external data providers for materiality mapping and controversy analysis. Engagement with companies includes explaining voting intentions, potentially also seeking collaborations with other stakeholders. The manager will selectively take token ownership stakes and bring behaviour deficiencies to the public’s attention in order to agitate for improvements. Consequently, the manager does not generally apply exclusion lists or negative screening, as they may seek to engage companies that have shortcomings. The manager evaluates firms based on circa 50 ESG metrics, on an absolute basis and also versus peers. An additional analysis by an independent specialist focuses on materiality and controversy categories. Some of the manager’s noteworthy ESG campaigns include accelerating an energy producer’s expansion into renewables and exiting coal, or spotlighting a chemical company’s environmentally harmful soda-ash practices (achieving an MSCI ESG Ratings downgrade for that company). The manager is a UNPRI signatory, leverages various ESG service providers and internal ESG training, and reports their ESG campaigns in detail to investors.
RI or ESG policies are one obvious area for improvement, as they should accurately reflect the manager’s investment approach.
Steps Towards Best Practice
We recognise that not every manager can or should overhaul their investment approach to move into a higher RI category. However, we do believe there are relatively simple steps that managers could take to enhance their ESG credentials if they so desire.
“We are tied down to a language which makes up in obscurity what it lacks in style.” - Tom Stoppard, Rosencrantz and Guildenstern are Dead
RI or ESG policies are one obvious area for improvement, as they should accurately reflect the manager’s investment approach. A manager’s policy should detail how ESG is viewed through an investment lens and how ESG factors are integrated into the investment process. The manager should have separate Corporate and Investment ESG policies. A non-exhaustive list of different areas that could be covered in an RI Dedicated manager’s ESG policy includes:
- Stating how the manager defines ESG or ESG factors
- Defining ESG standards for investments, and an explanation of the exclusion screening process if one is used
- Defining RI approaches the manager will implement
- Defining the manager’s approach to engagement and/or stewardship
- Outlining the manager’s approach to reporting on ESG/RI
- Putting in place a schedule for reviewing and approving the policy (e.g. annually)
ESG reporting can also be improved, though we note this is an industry-wide issue as there does not seem to be a consistent or best practice when it comes to ESG reporting. Some of the many approaches to ESG reporting we observed include:
- Engagement/impact reports: Managers who included activism or engagement in their process generally published this annually. The reports detail the steps the manager had undertaken to engage the management teams of the companies in which they were investing, and any results of those engagements.
- ESG report: Managers who were thematic, but not necessarily activists, generally published annual reports detailing:
- Alignment of specific investments to UN SDGs and/or ESG goals
- Their portfolio’s “ESG wins” – quantifying how the portfolio made positive ESG contributions, and highlighting the shortcomings or negative ESG impact of their short positions
- Portfolio-level ESG ratings, using their own methodology and scoring systems
- Environmental reporting: Less common – but more frequently found in environmentally focused strategies – was reporting on a portfolio’s carbon footprint and/or carbon intensity.
- The calculation of the impact of ESG integration on performance attribution was not common. Managers advised that this is too hard to isolate, as ESG is not the only driver of investment decisions.
There are many directions for hedge funds to take to reach RI dedication.
Conclusion
We believe this analysis illustrates the heterogeneity of approaches to ESG evident among equity hedge funds. This emphasises the importance of thorough due diligence in manager screening and selection, relating not only to whether a manager integrates ESG in their processes but how specifically they do so in practice.
“For all the compasses in the world, there’s only one direction, and time is its only measure.” We would have to disagree with Rosencrantz here; there are many directions for hedge funds to take to reach RI dedication. We see progress, best practice – and still much further to go.
1. Source: Preqin, ‘Will Hedge Funds Ever Truly Embrace ESG Principles?’, May 2019 (https://www.preqin.com/insights/research/factsheets/will-hedge-funds-evertruly-embrace-esg-principles)
2. Source: Bloomberg, February 2020 (https://www.bloomberg.com/news/articles/2020-02-06/why-hedge-fund-managers-say-they-avoidsustainable-investing)
You are now exiting our website
Please be aware that you are now exiting the Man Institute | Man Group website. Links to our social media pages are provided only as a reference and courtesy to our users. Man Institute | Man Group has no control over such pages, does not recommend or endorse any opinions or non-Man Institute | Man Group related information or content of such sites and makes no warranties as to their content. Man Institute | Man Group assumes no liability for non Man Institute | Man Group related information contained in social media pages. Please note that the social media sites may have different terms of use, privacy and/or security policy from Man Institute | Man Group.