With the ESG juggernaut gathering pace in financial markets, how hedge funds traverse short-selling challenges, tech advances, and the data “wild west” will be key to unlocking future returns.
Long seen as the preserve of traditional long-only buy-and-hold strategies, impact investing and sustainability-focused themes have gathered pace within the global alternative investment community over the past decade.
In times past, industry concerns centred around whether effective ESG implementation could ever be compatible with alpha generation. But as allocators place greater scrutiny on how their portfolios and investments can meet the expanding set of climate change, diversity and corporate governance challenges, an assortment of high-profile brand-name hedge fund management firms – including Man Group, Sir Chris Hohn’s TCI Fund, JPMorgan and Caxton Associates – have emerged as leading ESG advocates.
At the same time, successive industry studies continue to chart a sustained surge in appetite among investors for a greater focus on ESG within their hedge fund allocations.
In 2020, a wide-ranging study by Deutsche Bank found that ESG factors are informing the allocation decisions of roughly two-thirds of hedge fund investors. Meanwhile, in more practical terms, more than a third of investors (34 per cent) now actively allocate to an ESG-focused hedge fund strategy, according to BNP Paribas’ 2022 Alternative Investment Survey, compared to 43 per cent who do not, though a further 23 per cent are considering an investment. According to BNP’s study, published in March this year, more than a fifth of investors (22 per cent) expect their allocations to ESG strategies to increase in 2022.
The same study also found that 38 per cent of investors now invest in women- or minority-owned managers, up from 21 per cent five years ago. A further 18 per cent of those quizzed are expecting this to grow in 2022, and about a fifth are considering investing for the first time.
‘Huge opportunities’
“There are huge opportunities because there are huge problems,” says Edward Lees, co-head of BNP Paribas Asset Management’s Environmental Strategies Group.
He believes that investors keen on ESG themes – but nervous about increased exposure to market direction – may tilt towards the hedge fund space, such as market neutral and long/short strategies, amid the prevailing market volatility and economic uncertainty.
“We are now in an interesting environment, relative to last year – we’re moving from an environment from which the market was just trending up to where the market is now much choppier.”
That said, hedge funds and other alternative asset managers still face practical headaches when it comes to successfully implementing sustainability metrics and other factors into their strategies and utilising ESG to help deliver alpha – a key barometer of success in the hedge fund industry.
The continued lack of industry standardisation of the way certain factors – such as carbon emissions, socially-responsible management, and effective corporate governance – are identified, measured and quantified, coupled with the ongoing challenge of greenwashing, is now pushing some asset managers towards data and technology solutions.
With ESG data now seen as a hot commodity, AI, machine learning algorithms and natural language processing techniques can potentially help managers and investors contend with the rapid expansion of datasets and disclosure demands, and delve deeper into the at-times dizzying array of available information.
According to a report by SS&C and the Alternative Investment Management Association in September, there are now more 100 data vendors supplying the market with ESG scores, ratings and reports on companies based on company disclosures and independent research.
Quality not quantity
Speaking at an ESG-focused webinar in November, Richard Peterson, director and product head of credit data and analytics at FIS, and a member of the firm’s steering committee for integrating ESG initiatives, suggested large parts of the investment management industry are “still in the wild west” when it comes to ESG analysis of companies and the level of data provision – adding that the social and governance elements of ESG remain trickier to quantify and benchmark.
My-Linh Ngo, head of ESG and portfolio manager at BlueBay Asset Management, says technological advances such as AI and NLP can help investors and managers collect and analyse larger volumes of data more easily and faster than humans, which in turn can better help identify trends.
“ESG data is necessary but not sufficient in and of itself to do ESG investing well – it needs to be combined with the necessary tools, analytics, and expertise to effectively interpret it and inform decisions,” says Ngo. “While in some cases there is a case of there not being enough information, in others, there is actually too much. The issue is quality and not quantity.”
While the increased volume of ESG data is likely to lend itself more immediately to quantitative and computer-based hedge fund strategies, Ngo also believes improvements in data processing will also allow fundamental and discretionary managers to better cut through the sizable swathes of information in order to strengthen investment theses.
She says: “Traditional strategies will find value in applying these to identify quality investments which will be stable over the long term, whilst other quant strategies can benefit from acting on the shorter to medium term signals generated, which over the long-term means they may still hold their own performance-wise as well.”
A state of flux
With market authorities now circling the worst carbon emitters, and ESG playing an ever-greater role in allocator decisions, the ways in which different hedge fund strategies are best suited to applying responsible investing techniques are now firmly in the spotlight. As well as heralding major implications for investor flows into different segments of the industry, it could also recalibrate the ongoing discretionary-versus-quant debate, market participants say.
Reflecting on the broad spectrum of hedge fund types – from traditional long/short bottom-up fundamental stock-picking strategies and discretionary activist approaches to algorithm-based quantitative funds and AI trading which remove human emotions from the investment process – James Jampel, founder of HITE Hedge Asset Management, believes quant methods will face greater challenges than discretionary and fundamental approaches when it comes to building successful ESG-friendly portfolios.
Noting how government policy, regulatory initiatives and investor sentiment are all in a state of flux, Jampel explains: “In a world where the future is going to be so different from the past, it seems less appropriate to use quant analysis where you’re implicitly assuming the future is going to be something like the past. We are fundamental analysts, and fundamental analysis allows for discontinuities and sharp break points.
“Count me as a sceptic about whether ESG factors will be predictive of returns.”
He continues: “The quants, by their nature, are not going to be activists – they’re not going to take positions on boards and vote. The only argument they can make is that their shorts are more carbon intensive than their longs. That’s the only way they are going to attract any capital within these ESG frameworks. The quants might be good at generating alpha for investors – in the end, hedge funds are there to make money – but it’s only going to be considered impactful from a cost of capital standpoint.”
Speaking at EisnerAmper’s 6th annual Alternative Investment Summit last October, Scott Radke, CEO of New Holland Capital, pinpointed how various strategies are utilising both defensive and offensive approaches. The defensive approach centres around risk identification, with bottom-up equity and credit strategies zeroing in on the earnings or balance sheet implications of an environmental or social event or catalyst in order to develop trading themes or investment ideas. Meanwhile, the offensive implementation involves managers building portfolios specifically designed to have an impact orientation.
Short shrift?
Over the past decade, the traditional asset management approach towards impact investing has evolved from divesting out of ‘bad’ companies towards more activist-style stances, taking stakes in companies and agitating for change at the management level.
But this shift is now posing a conundrum for investors who are mandated to curb their portfolios’ carbon net financing.
“They are unsure if they should be increasing their net financing of high-carbon entities now, and then using their influence in trying to change those entities over time, or if they should be decreasing their carbon net financing immediately by divesting,” Jampel says.
“Do allocators today want a high ‘carbon footprint’ set of managers, however defined, that have potential to make change or, instead, a low carbon footprint in order to ensure they are not seen as financing or profiting from high emitters in the short run?”
Crucially for the hedge fund community, this has also thrown the spotlight onto how allocators and policymakers view short positions – a key tool in hedge funds’ trading arsenal.
Hedge funds’ ability to take short positions and hold derivatives creates an added dimension of different exposures, risks and ESG characteristics, further complicating the carbon footprint debate. Industry participants say shorting ESG-negative companies may also prove more effective in instigating change, rather than simply taking long positions and agitating for reforms.
Jampel believes the biggest regulatory risk for hedge funds is that future ESG standards are written in a way that fails to acknowledge how shorting and the use of derivatives operate. Specifically, the key issue centres around whether allocators should screen on a simplistic model of current carbon ‘footprints’ at all – or if a more sophisticated and inclusive model based on the potential to affect change is more aligned to the net-zero economy.
He says hedge funds firstly need to argue for the use of this more comprehensive model of potential for influence. Secondly, if current financing is to be used as a metric, hedge funds need to ensure shorting is included as negative in that calculation – and not erroneously ignored.
“You will hear critics argue that shorting has never removed a single tonne of carbon from the atmosphere. But then selling a long position and divesting doesn’t either. This is a red herring that needs to be debunked,” Jampel says.
“The short book has to be thought of completely differently to the long book. Shorting is not investing – it is a financial transaction in which you will profit if the stock goes down. Shorting is not financing a company. Intellectual consistency demands that shorts be counted as negative carbon financing.”
Jampel explains how HITE Hedge’s High Carbon Offset strategy takes short positions in the heaviest carbon emitters and goes long those companies that are not the heaviest carbon emitters.
He says: “Our biggest concern is that if major bodies come out with language that does not allow shorts or derivatives to be counted, then our portfolio will appear to be one where we are net financing emitters and profiting from them, when in fact we are not. The challenge we have is convincing potential allocators that we can – and do – have an ability to decrease their financial risk of owning emitting companies that we are helping move in the right direction. That will become more difficult if the regulations are written in a sub-optimal or less-than-thoughtful way.”
Additionally, more fundamental questions surrounding the ethics of short-selling – and whether the practice ultimately contradicts the spirit of responsible investing – remain the subject of some debate.
In a July 2020 commentary on short-selling and ESG, AIMA and Simmons & Simmons noted how shorting can be used to trade on ESG concerns over corporate governance, environmental issues, and alleged human rights abuses, helping expose failings of issuers and bolstering market transparency for investors. The report highlighted short-sellers’ early public campaigns against Wirecard AG, the scandal-hit German e-payments firm which collapsed in 2020 amid accounting fraud.
“There is a lot of debate around shorting, and whether you should be shorting bad companies and bad industries,” observes Patrick Ghali, managing partner and co-founder of global institutional investment advisor Sussex Partners.
“You have the purists who say you should not be making any money shorting, for example, fossil fuel companies because you are benefitting from a negative. Then there are other people who say you should absolutely be shorting them and making money from it because, first of all, you will be generating returns, and secondly you might also be able to force them to change their ways and take an activist approach that might be beneficial. There is still ultimately no consensus.”
Read the full Hedge Funds & ESG: Navigating internal change and responsible investing Insight Report here.