“A very real phenomenon”: how ESG is shaking up the manager-investor dynamic

Earth from space

Once regarded as something of a fringe concern, responsible investing and ESG (environmental, social and governance) themes have steadily gained momentum in recent years, becoming a key component in many of the world’s biggest and most successful hedge fund strategies.

Sir Chris Hohn, founder of the USD28 billion activist-focused firm The Children’s Investment Fund (TCF), is one prominent advocate, having stepped up his campaign against companies failing to act on climate change. 

Earlier this month, Hohn – whose fund gained more than 40 per cent in 2019 - called on Barclays, HSBC and Standard Chartered to withdraw financing for new fossil fuel projects.

“Investing in a company that doesn’t disclose its pollution is like investing in a company that doesn’t disclose its balance sheet,” Hohn wrote last year. “If governments won’t force disclosure, then investors can force it themselves.”

The pace of change suggests ESG is no longer simply a “luxury” within the investment management industry, say some market participants. They contend it is not enough for hedge funds to just tweak their investment strategies around the edges in order to make them more “green”.

“The next generation after us do not see this as something optional,” one hedge fund prime brokerage head told Hedgeweek. “It’s a very real phenomenon – it’s now here to stay.”

With a range of marquee-name hedge fund firms – including Man Group, Caxton Associates, and JP Morgan – joining the ESG fray in recent months, sustainability concerns and ESG angles are radically shaking up investment decisions on both ends of the manager/investor dynamic.

“When a manager goes through an operational due diligence screen now with some of the bigger allocators, the ESG component is very real,” the prime brokerage official says. “It’s not just a box-ticking – a lot of people have fundamentally changed things. A lot of managers have absolutely changed, or rather altered, their investment styles to be ESG compliant.”

Sin stocks

Hedge funds have long explored company governance factors when selecting stocks for their portfolios. But according to Magnus Spence, head of alternative investments at Jupiter Asset Management, the acceleration of ESG is prompting hedge fund managers to not just focus on governance when picking stocks, but also zero in more closely on the impact of the environmental and social issues on portfolios.

In a commentary last year, hedge fund industry stalwart Spence pointed to JP Morgan research that suggests an absence of ESG factors within long/short portfolios can heighten volatility, lower Sharpe ratios and increase potential drawdown sizes.

“There is evidence and coherent academic argument to indicate that over the longer term, a focus on ESG can lead to outperformance for asset managers in general, including those who pursue hedge fund strategies,” he observed.

Amid the continued rise of ESG investing, there is a growing sense within the prime broker community that commodities-focused strategies are increasingly feeling “left out in the cold” as they continue to trade established oil and coal names – so-called ‘sin stocks’ typically seen as non-ESG compliant. That, in turn, has considerable implications for share prices and stock prices in the long run, the broker noted.

Indeed, debate continues to rage over whether strategies focused on ‘responsible’ investing should be actively betting against certain stocks – such as oil drillers, tobacco companies or weapons manufacturers.

One London-based portfolio manager, running a sustainable investing hedge fund strategy with the ability to short, believes the practice can help drive change among company management.

“We’ve had some push back on the short side from some people who argue that if you’re truly socially responsible you shouldn’t short,” the manager told Hedgeweek. “Some people take issue with the fact that funds are shorting, and feel that betting against a company is something that’s morally wrong.”

Investor appetite

Meanwhile, as large investors continue to grow their ESG allocations, this push is driving demand for new sustainability-focused products to fill that allocation.  

Close to half (45 per cent) of institutional investors now see their allocations to ESG-focused hedge funds as a route into alpha-generating opportunities, according to one industry poll published last month.

The wide-ranging survey by published jointly by KPMG, the Alternative Investment Management Association (AIMA), the Chartered Alternative Investment Analyst Association (CAIA), and CREATE-Research, found ESG methods are incorporated into processes in a range of ways: through the  general investment process, through the exclusion of certain non-ESG securities that clash with investors’ personal values, and via shareholder engagement.

“It isn’t just a marketing gimmick – everyone’s pension fund will have an ESG demand on it,” the brokerage official notes. “When you run a hedge fund, you’re not running your own money – it’s somebody else's money.” 

He continues: “So whether it’s pension fund money, or insurance company money, or even fund of fund money, there are end clients who feel passionately about ESG. If you’re managing pension fund money, those underlying teachers, firefighters, and police all have strong views on all of this.

“Anyone who is arrogant enough to think that managers and investors are simply paying lip service to ESG is making a mistake.”