The Wheat and the Chaff - A Guide to Rating an RI Fund Manager

Introduction

The growth of responsible investing (‘RI’) in asset management has been staggering. More and more allocators are demanding that their capital be invested responsibly, and such expectations are increasingly finding their way into hedge fund allocation decision-making. RI adoption is in its relative infancy within the hedge fund industry, unlike traditional or private markets sectors. It is widely accepted, and reinforced by investment managers, that RI adoption is hindered by the availability of good quality ESG factors data. As a result, allocator expectations of hedge fund firms practicing RI are still evolving, as are the hedge fund firms’ considerations of the RI merits in managing these allocator expectations.

As with any nascent industry, and we would classify hedge funds incorporating RI in this context, it is often hard to distinguish genuine innovation from the hype. As more and more assets come with RI strings attached, investment managers are incentivised to exaggerate their RI credentials to gain access to capital. To further complicate matters for allocators, there is a broad acknowledgement that the lack of industry-recognised RI definitions is hampering objective interpretation which makes it difficult for hedge fund managers to meet all the RI needs of its investors and for allocators to easily benchmark portfolios of hedge funds.

It is therefore more important than ever that hedge fund investors are able to separate the wheat from the chaff to distinguish genuine responsible investment managers from those that greenwash. When it comes to investment due diligence, allocators should be very aware of such a greenwashing risk when evaluating RI at each of their investment managers. Outlined below is what we believe is best practice when assessing an investment manager’s RI credentials. An allocator may want to devise a scoring methodology to reflect ‘good’ from ‘not so good’ findings to construct an overall assessment – we have included an illustration of what an allocator’s overall portfolio of hedge fund investments could look like having followed a structured investment due diligence process (Figure 1).

The Need for an Explicit RI Policy

Even before meeting an investment manager, we believe allocators should request to see the firm’s RI statement or policy. Not all investment managers will have such a document: some will have an RI statement; some will have a full-blown policy; and some have no formal written RI guidance at all. An allocator should prefer a firm to have a formal policy document.

There are clear differences between a statement and a policy. A statement is an aspirational document, giving a sense of the firm’s overall direction on RI issues, but which probably reflect the firm having less internal governance measures in place to dictate positioning. In contrast, a policy should be a clear, structured outline of how the firm handles RI. In the event of a regulator turning up, the firm should be able to prove that the policy is materially followed for its investment strategy/ies.

Analysing the RI documentation before meeting with the investment manager not only provides a framework around which an investor can structure later discussions, but also gives a good initial sense of how seriously an investment manager takes the RI element of its business. Even for investment strategies that lend themselves less to RI consideration, we believe allocators will still want to understand the investment manager’s stance through a policy document.

Those investment managers which score most highly have an RI policy which governs the entire or vast majority of the investment process and is overseen by senior management who have an explicit responsibility for its application. The best-in-class show a clear understanding of RI approaches, referring to industry-wide initiatives such as the UN Principles of Responsible Investment (‘PRI’), when detailing how the strategy incorporates one or more of these approaches. Looking forward, the UN Sustainable Development Goals (‘SDGs’) are emerging as the global framework for governments. We believe it is only a matter of time that such measures will find their way into allocator wishlists of investment managers and that the SDGs will offer a common reporting mechanism.

At the other end of the spectrum, the lowest-scoring managers generally have a non-descriptive or bland statement, with no clear guidance on how this will be consistently applied to the day-to-day running of the firm’s investment process.

Applying the Policy to Investments

This brings us to the next stage of understanding exactly how RI policies will be applied to investments. It is important that investment managers are able to demonstrate how varying RI approaches are suitable to their own particular mandate. This can be divided into six broad categories:

• Thematic / Impact-investing – where the investment strategy is aligned to one or more of the 17 UN SDGs. Such an alignment is not widely seen at present given its infancy in hedge funds;
• Stewardship – where investment managers actively engage with companies they own;
• Positive screening – where investments in those companies are perceived to be ‘best-in-class’ on RI metrics;
• Generally integrated without regard to targeting above-average RI scores, but as an important factor in the investment decision-making process;
• Negative screening – where investments perceived to be harmful are placed on an exclusion list;
• No RI at all.

Not every investment manager can offer every approach, and it would be foolish to demand that they did. For instance, many systematic hedge funds, especially CTAs, would be unable to provide any evidence of stewardship at all – it is simply incompatible with the type of strategies that they run. Nor should allocators abandon the diversification benefits of differing strategies, simply because some don’t fit a stewardship framework.

For discretionary investment managers, the bar is somewhat higher. The best investment managers may undertake a combination of approaches – usually with a negative screen excluding certain asset classes and sectors regarded as the most harmful on an ESG basis, and then applying a research heavy RI integration process to identify sector leaders. Active stewardship, with funds using their voting rights to affect company policy and engaging with company management to drive positive change, is something which only the best RI investment managers are able to enact convincingly. If investment managers say that they take a stewardship approach, they should be able to demonstrate a track record of consistent voting and corporate engagement that they have either achieved or advocated for positive change.

The Devil Is in the Detail: Resources, Research and Monitoring

By this point in the discussions between allocators and the investment managers, it should be relatively clear how the strategy in question lends itself to RI. The next step would be to take the discussion to a more granular level and attempt to understand how the firm’s investment/ research personnel take responsibility for the RI analysis and how the RI policy is applied to individual trades.

First, we believe allocators should look at the firm’s resources in terms of personnel: is the person in charge of RI decision-making a generalist with an extra ‘RI’ hat? Or does the firm have a dedicated RI team? If there is a dedicated RI team, how does it interact with the financials investment/research team in the firm? It is more likely that only the larger equity long/short hedge fund firms will have the resources to build a dedicated RI team. We believe that allocators should focus on understanding exactly which person within the team is responsible for ensuring investment decisions reflect the firm’s overall RI commitment. In firms which are more likely to greenwash their credentials, RI responsibility is likely to be diffused. In contrast, best-in-class firms will establish an explicitly embedded process, with defined roles and responsibilities throughout the investment process.

Secondly, investors should delve into what sort of RI research is being conducted. Does the firm just subscribe to bulge-bracket broker RI research or is a deeper-dive analysis being conducted, such as employing an ESG data vendor? It is worth noting here that the industry has further to go in creating a more robust ESG company rating system that offers greater consistency between ESG data vendors and hence confidence for its users. Some investment managers believe these ESG vendor differences/biases are identifiable and are thus able make full use of these inputs.

Third, accountability should be a key theme in these discussions, in our view. The investment manager should not only have a clear idea of what its policy is, but who should be enforcing it and how it measures RI success.

Indeed, measuring success is arguably the hardest part of appraising an investment manager’s RI credentials. While some managers are able to calculate the P&L impact of an RI investment, it is important to acknowledge that this is quite difficult to do given most investment strategies will have a number of factors feeding into an investment decision. Allocators should give credit to investment managers that can demonstrate its unbundling of the various investment factors to highlight the RI impact on an investment/ portfolio P&L. Clearly, comfort needs to be gained by the allocator that the one/few examples provided are typical for the broader strategy invested in. Investment managers may be proactive in providing a few examples in its formal investor reporting, but should also be able to provide further examples upon investor request.

A Case Study

This is probably best illustrated with an example, using a hypothetical discretionary equity long/short fund which takes a positive screening RI approach.

Let’s assume that the discretionary trading hedge fund firm in question is demonstrating its RI credentials to the allocator using a recently traded buy position in an oil and gas company.

• While the portfolio is managed under a positive screening RI policy, it is explained to the allocator that this does not mean that companies in the oil and gas sector are automatically excluded. However, it does mean that the investment manager should be able to demonstrate the positive screening process and how it seeks to invest in companies which lead on RI issues in the oil and gas sector.
• The hedge fund firm has recently enhanced its existing order management systems to require the investment analyst to enter a RI narrative as part of the investment thesis submission process; the firm is able to demonstrate this by walking the allocator through its system. (Note that if the investment manager operates a more manual process, then it is important for the allocator to be able to walk through this process with appropriate personnel at the hedge fund firm and understand any control features that formally embed the RI policy into day-to-day investment activity; engaging with a controller at the investment manager, such as the COO or CCO, should provide the allocator with a good insight into this embeddedness and arguably better manage potential conflicts.)
• The firm is able to demonstrate to the allocator that its investment committee challenged the analyst over the proposed trade’s RI credentials before approving it (the committee meeting is minuted to provide a permanent record). The firm’s analyst successfully argued that the oil and gas company’s direction was positive: it had recently expanded its operations by buying windfarms, and its annual report had set a target that 50% of revenue would come from renewable energy sales by 2030. In addition, while the oil and gas company had below-average ratings on ESG metrics compared to the broader indices, it was the best-performing energy company within the oil and gas index. (Note that for higher volume discretionary trading strategies, or multi-portfolio manager firms who each may follow different RI strategies, investment decisions maybe made at a portfolio manager’s desk. As such, it is important for the allocator to understand how the RI investment factor is formally presented in the research thesis document and that this written form is stored centrally in the firm’s systems and is accessible by the firm’s controllers.)

In summary, not only should the trade be justified on an economic basis, but the fund has a formal mechanism for decisions to be challenged (the investment committee or other formal process), with the CIO or portfolio manager taking a lead by acting as a ‘red team’. Moreover, by keeping formal records of the initial analysis, the challenges presented and an ongoing plan to monitor the investment, the fund has a clear methodology which ensures that decisions are defensible on an RI basis. If the oil and gas firm does fail to make progress towards its target, this will become apparent, and the fund can either increase pressure on the management or exit the position – both actions would avoid a charge of greenwashing.

A Focus on the Future

At this point, we would stress that the above case study is an example of best practice. Because of the relative novelty of RI investing, not all firms are likely to have such a process in place. Furthermore, for smaller funds, processes may be more informal: a fund with a team of two may have a robust level of challenge when researching positions, but it is likely that a lot of this may take place informally. As in all businesses, large funds have more resources to create formal procedures, and as such, investors should adjust their expectations accordingly. Note that this does not mean that investors should lessen their standards, but should instead recognise that smaller organisations are likely to have less resources (both personnel time and finances to enhance existing research databases) in an effort to formally embed the RI nuances.

We believe it is important to gain an understanding on the investment manager’s direction of travel. Is the firm committed to improving its research processes, portfolios and ultimately, its RI standards? Both big and small firms should be able to explain their roadmap for the next few years, showing an understanding of where their current standards may be falling short and identifying the actions they will take to improve. Will a small firm start buying dedicated RI research instead of waiting for generic bulge bracket research to mention ESG issues? Will a large investment manager consider dedicated RI research staff, or developing its own RI metrics to improve on publicly available data?

As well as building new capabilities, investment managers should be able to explain their plans for their assets under management. More and more mandates have an explicit focus on RI, with particular ESG metrics built into portfolio construction. But funds should also have a plan to incorporate RI into their legacy mandates as far as possible, even though older mandates may not allow for a complete application of RI principles. Understanding these future plans will enable the allocator to benchmark the investment manager as part of an ongoing monitoring process and ultimately determine if the direction of travel is on track.

Scoring RI Managers

Completing the investment due diligence allows an allocator to score each of its hedge fund holdings. Figure 1 is an illustration of how an allocator may think about summarising the investment due diligence findings. Over time, such an illustration can be used to map progress of each investment manager (hopefully moving to the right!).

Figure 1. Assessing RI Managers

Source: Man FRM. For illustrative purposes.

Conclusion

The rapid growth of responsible investment in the asset management industry means that it is often hard to distinguish those investment managers serious about RI and those that overpromise with an eye on this increased investor demand.

We recognise this difficulty and as a result, we believe allocators need to focus on an investment manager’s RI policies, personnel and investment decision-making process to best navigate their way. Of course, not all funds are able to operate at the same level, but there should be a plausible indication of the direction of travel. A further challenge to leave you with, and a very important one, is for the allocator’s investment due diligence process to enable comparison across its various hedge fund holdings; being able to effectively do this will result in more effective ongoing monitoring as well as facilitating any reporting requirements.