Hedge funds are the ESG bellwethers – do they know it?

Robert Quartly, Janeiro

By Robert Quartly-Janeiro – There is a lot of talk about ESG. It dominates column inches and pitch decks at levels unimaginable only a decade ago. The need for companies to adopt and integrate ESG is imperative if environmental issues – the hardest and most important component – are to be resolved in the coming decades and a mass extinction avoided.

Yet greenwashing and futuristic announcements about “we will do this by 2030, 2040, et al” are reaching epidemic levels, making it harder to differentiate companies with genuine ESG ambitious from those with inferiority complexes and a fear of missing out.

At the same time, hedge funds hold a mythical and feared reputation in public minds, with significant performance fees suggesting (largely unfairly) a culture of greed. Sure, bad actors exist, but no different from any other industry. Instead, hedge funds in my experience are filled with contrarian views, political hawks, independent thinkers and analysts who, yes, want to make money for clients and themselves, but who are, more accurately, concerned with capital preservation, downside protection and outperformance.

What is interesting is that hedge funds and ESG are natural if not unusual bedfellows. To explain, if the GameStop and Cineworld squeezes show anything it is that activists and short-sellers are the tip of the hedge spear for both market foresight and societal anger. Yet, if the corporate scandals and malpractice - Volkswagen, DuPont, BP, Amazon, Mckinsey, Apple, Tesco, to name a few – of recent years are anything to go by then things will only get worse as some companies carry on like nothing is happening, and those with true ESG credentials are sued more often research suggests.

Moreover, Nikola Inc is an interesting example in that it demonstrates the role short-sellers have in holding companies viewed as future ‘Captains of ESG Industry’ to account. In addition, it demonstrates the pressure on these types of companies to deliver leading ESG products and positions that are not easy to obtain. Separately, when Elliot Capital Management took control of AC Milan following poor governance, it showed what an activist approach can achieve in driving performance and recapitalising a business for stability.

Equally, it is indicative that the flow of retail investors’ capital flooding markets with volume, and ETFs buying anything with an ESG stamp, means that hedge funds and asset managers need to adopt and communicate their role as the policemen of global markets, separating the real from the perceived.

True, not all activists are born equal and raiders lurk. But fund managers have to ask themselves this: Are you going to let Larry Fink’s letters to CEOs dominate a space that requires independence and strategic asset allocations (and the AUM that comes with it), especially considering BlackRock has been softer on ESG than its PR suggests, and companies need to perform across E, S, and G, not just one or two areas – many are there to be found out.

Interestingly, analysing companies in Greece it has been shown that by shorting or exposing firms with poor ESG, hedge funds are protecting investors until markets and regulators duly catch up, much like Wirecard in Germany.

However, a key distinction from a short perspective, and something missed in the GameStop trade, was that companies with “redundant business models” can err a general sense of nostalgia toward them, creating anger at fund managers looking to make a buck, even if the fundamentals support it. Yet poor ESG is completely different, and with the consciousness consumers and investors have for what is considered ESG/responsible - or not – there is a growing herding to crush firms that are not.

Similarly, companies with models “incompatible” with ESG – such as mining, steel and cement producers – are in truth critical cogs in the ESG transition. That said, activism not divestment is a more powerful approach. Much like private equity firms flooding the world with IPOs, activists have a tremendous opportunity to educate boards, explain the thinking to the world-at-large, and revolutionise business models so that holdings become ESG leaders, or punish them with shorts if they do not.

Let us be honest – much of the S and G aspects are easy to integrate across business models if there is a desire to integrate. And even though it requires is a long-game approach, the levels of greenwashing and misinformation around ESG offer an opportunity for hedge funds to not only position themselves as furthering it through activism, but also as protecting investors and society from underlying ESG issues through shorts – a step change in perception, investment strategy, and communication.

What is telling about hedge funds and ESG is that only 3 per cent of hedge funds run ESG strategies, at a time when USD40 trillion in assets are now ESG-focused (compared to hedge funds’ AUM of USD823 billion, according to BarclayHedge). So the potential is there.

The research, analysis and tactics employed by hedge funds, so publicised in ‘The Big Short’, ultimately make them bellwethers for ESG investing in ways that drive returns, increases AUM, and builds understanding and trust by seeking out the good, the bad, and the ugly.

Robert Quartly-Janeiro is Visiting Fellow at the Hellenic Observatory, London School of Economics

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