As governments strive to meet sustainability targets, the global push for more formalised ESG standards and frameworks is bringing challenges – as well as opportunities – for hedge funds amid a fractured regulatory landscape.
With the climate emergency increasingly at the centre of the political agenda, and the focus on environmental, social and governance (ESG) factors in financial markets and investment management continuing to expand, global market regulators are driving ahead with the establishment of formal ESG rules and frameworks.
The European Union’s Sustainable Finance Disclosure Regulation (SFDR) – which took effect in March 2021, and forms the core of the bloc’s financial markets sustainability push – now applies to a broad scope of financial firms, advisers and products. In addition, the SFDR will, from June this year, require investors to start collecting data on companies in which they invest, with a view to reporting the following year. The SDFR’s Level 2 requirements – which include mandatory principle adverse impact statements and other voluntary areas covering valuation risks stemming from environmental impacts – will also take effect in January 2023.
Across the Atlantic, meanwhile, the Securities and Exchange Commission under chairman Gary Gensler has unveiled proposals to shift from a more voluntary, principles-based approach in climate reporting to mandatory disclosures for US companies, with factors such as greenhouse gas emissions included in audited financial statements. US authorities are also setting out plans for increased disclosures for ESG-focused investment funds. In Asia, China is partnering with the EU on ESG taxonomy criteria, while Hong Kong regulators are increasing their focus on climate reporting standards.
Leading the charge
As hedge funds of various shapes, sizes and strategy types look to capitalise on the growing opportunities in sustainable investing, the need to better quantify and assess ESG risks in portfolios and positions is coming into ever-sharper focus.
My-Linh Ngo, head of ESG investment at BlueBay Asset Management, notes how the European sustainable finance-related regulations is set to make a “deeper mark” on financial market participants and issuers, adding that the ongoing rollout of the SFDR regulation, green taxonomy and MiFID sustainability preferences will be added to the mix.
“There’s no doubt that Europe has led the charge on the regulatory front,” says Edward Lees, co-head of BNP Paribas Asset Management’s Environmental Strategies Group and co-manager of its long/short Environmental Absolute Return Thematic (EARTH) strategy. “All of these initiatives are trying in their own way to steer money towards more responsible ends, and ESG is the shorthand for that – responsibility across not just the environment but also social and governance issues.”
But despite the substantial drive towards a more formal framework – and initiatives such as the UN Principles for Responsible Investing (UNPRI), which now has more than 3,500 signatories spanning asset owners, asset managers, and service providers with assets totaling some USD3 trillion – market participants concede the global regulatory landscape is set to remain fragmented.
In a wide-ranging study published in January, Barclays noted that although the IFRS Foundation’s International Sustainability Standards Board has initiated work this year on global reporting requirements for national frameworks, there is still no international market standard for disclosing sustainability information on companies.
This, in turn, potentially heralds sustained ESG integration and transparency headaches for hedge funds and other investment managers.
My-Linh Ngo believes the investment community – particularly those managers marketing in different countries – faces challenges as ESG issues become more complex, with varying approaches emerging from different jurisdictions.
“Clashes of cultural biases, as well as of political and economic agendas, are not a good recipe for harmonisation and standardisation,” she observes. “For instance, the European taxonomy of what activities are ‘green’ may differ to what those North America or emerging markets define as being sustainable. In terms of what products constitutes ‘ESG’ may vary from one market to the next.”
As well as regional divergence, progress also differs across the constituent environmental, social, and governance components of the ESG sphere.
“From our standpoint, we really focus on the ‘E’ in ESG,” Lees explains of his fund’s investment strategy. “We view ‘E’ as being where the world’s existential problems are. We view ‘E’ as being where the billions of government expenditure is focused. We view ‘E’ as where the huge demand for solutions is from corporates and from people. This is where the cry is at the student level for endowment divestiture; this is what Extinction Rebellion is taking to in the streets. You don’t see similar movements on the other two verticals quite as much, in part because environmental issues are in our newspapers every day.”
Lees believes this is partly underpinning the drive among regulators towards stronger climate regulation.
As market authorities push ahead more environmental-focused measures, and industry participants note how the governance element has also emerged as a key component of investor due diligence in aftermath of the 2008 global financial crisis, there remains a need to further bolster the ‘S’ or social element within ESG frameworks, outlines Manuela Cedarmas, head of ESG & Impact Investing at Investcorp-Tages, the global asset management and seeding firm.
“The fact that the EU regulation is still behind in terms of the social taxonomy compared to the environmental one says a lot about how complex the ‘S’ part of the work is,” Cedarmas observes. “This is common to all the strategies and all geographical areas, but it’s one side where we see the biggest differences in approach and evaluation from managers.”
Ngo says that beyond environmental sustainability, work on social taxonomy and the focus on human rights is expected to progress in 2022. The EU’s Platform on Sustainable Finance is in the initial stages of setting out plans for a Social Taxonomy, to help financial markets participants to better explore how a company’s economic activity is socially-responsible.
“Europe is not going to be alone in its efforts as the UK and other jurisdictions look to define their takes on ‘avoiding harm’ and ‘doing good’ in terms of economic activities and entity-level conduct,” Ngo adds. “With ESG data and ratings increasingly emphasised as the basis for firms evidencing their credentials, the quality, reliability and comparability of these mean providers will also come under greater scrutiny this year.”
Salvatore Cordaro, co-CEO of Investcorp-Tages, believes that ‘S’ is the one part of ESG where there continues to be sharp differences among managers in the absence of a coherent, codified framework. “In the US, the focus may be more on diversity and inclusion, whereas in Europe it may be more about equality and health & safety, and other aspects, for instance,” he observes.
Headaches and hurdles
Mirroring this fractured regulatory backdrop, recent industry data suggests hedge fund managers and investors are ultimately split on how they can best integrate ESG factors into their risk and investment processes.
A poll of fund managers, funds of funds, corporate pension funds, endowments and others in North America and EMEA by Vidrio Financial, the alternatives-focused software-as-a-service and data management firm, in November found that a lack of clarity over standardisation, data clarity and comparability is regarded as a major hurdle in ESG integration.
More than 40 per cent of respondents pinpointed ESG data comparability challenges as a key integration barrier, while a quarter of those quizzed cited confusion over what constitutes best practice as the primary roadblock. Some 16 per cent of respondents meanwhile said that calculating ESG-specific performance is the main hurdle to integration into portfolios.
Reflecting on how hedge funds and other asset managers can more effectively incorporate ESG factors into their portfolios, Lees cautions against leaning too heavily on scoring or ratings, instead suggesting portfolio managers and investors should look to carefully deconstruct each element, utilising their own research and analysis capabilities – and not see ESG as a general cure-all or panacea.
“‘E’ is different from ‘S’, and ‘S’ is different from ‘G’. Each one of those things needs to be evaluated through a whole host of different KPIs,” Lees says of his approach. “When you look at a sub-list of KPIs, it can be a useful tool because it can give you a bird’s eye view of a lot of different issues with ‘E’, ‘S’, and ‘G’, and you can spot individual red flags which you can then investigate further.
“The problem arises when you try to add that all up into some number that summarises everything. You then aspire for that number to be comparable to other companies’ numbers, so that you can actually make decisions about relative merits. You end up adding and comparing apples and oranges.
“What if there are two companies in different industries, or different countries? People who are pulling it together generally aren’t doing detailed company analysis – they’re looking for a way to import third-party data and do a lot of math on top of it. Whenever you try to pick an easy, systematic way, you’re going to get false positives and false negatives. It doesn’t mean that it isn’t still useful in some ways, but I personally think the most useful ways to get a look at those underlying KPIs.”
According to Barclays’ ESG special report, ‘The Transition Mission’, this ongoing lack of industry standardisation raises both the spectre of crowded trades in certain stocks – potentially squeezing hedge funds’ performance – as well as hampering hedge funds’ efforts to ultimately strengthen their ESG practices.
“Portfolio managers may see divesting bad apples as the path of least resistance to align with regulation, in turn leading to best-in-class ESG assets receiving oversized flows, and thereby increasingly impacting future returns,” Barclays noted in its study.
“Ratings can help simplify,” says Cordaro. “But as with anything in life, when you try to simplify, you make your life easier but you lose the complexity around those things. My view is that uniformity brings common behaviour – and ultimately an increase in systemic risk, crowding and so forth.”
‘Great advantage’
In the end, might the continued absence of common industry standards on ESG ratings or a globally-agreed regulatory framework actually offer hedge funds an advantage in their quest to get a lead on their competitors and generate alpha for investors?
The lack of standards represents a potential opportunity for those managers able to utilise their research and analysis capabilities to zero in on differences between good and bad companies and take advantage accordingly, says Manuela Cedarmas, who notes how differing perspectives across the hedge fund manager community lead managers to contrasting but still equally valid approaches.
“Given that there are still no standards across the globe, this represents even more of an opportunity for the hedge fund space,” she notes. “That’s why for us it’s important to talk to managers to understand the way they look at ESG, given that that there is no one standard method.
“It’s important for investors to understand how different managers in different strategies and in different geographies are actually taking those factors into consideration.”
What’s also important, adds Cordaro, is the value of the work that hedge funds – or any asset manager – can do beyond the ratings, no differently than with other established market metrics, such as credit ratings.
“The ratings are there to synthesize and simplify. But in that simplification, you lose a lot of nuances which sometimes can become incredibly important. Yes, over time we will get to a place where ratings might become more homogeneous than today, but in my opinion we will never get to a place where you will have just one standard framework. This is not about rules, it’s also about interpretation – and with ESG in particular, the interpretations, stemming from different values, are not always consistent.
“For instance, is it better to “punish” oil producers, or try to encourage them to move into a clean energy space? There is not an easy black-and-white answer. Ratings can help guide you, but they will never provide you with a comprehensive answer.”
He continues: “Hedge funds have the great advantage in that they don’t use a benchmark, they can use different instruments and tools, including the ability to short. That’s not a trivial thing, especially for sectors that need to transition from an old technology, or an older business model, or an older way of doing things to a newer, more ESG-compliant way.
“The ability to be long and short can definitely help generate more significant alpha.”
Read the full Hedge Funds & ESG: Navigating internal change and responsible investing Insight Report here.
