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Hedgeweek Global Outlook 2022 – Chapter Four: ESG

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Jamie Kramer, Head of the Alternative Solutions Group, JP Morgan Asset Management

We expect to see a continued growth in appetite, as hedge fund managers increasingly seek out the alpha associated with companies making sustainable transitions that are not yet priced in by the markets. Investors will continue to look for and encourage hedge fund managers to enhance their business practices through the development and improvement of Corporate Social Responsibility programmes, with a specific focus on diversity, equity, inclusion (DEI) and the environment. The traditional approach to ESG exclusions will likely not be enough for many investors, particularly those that question the merits of divestment and are increasingly looking to drive change via shareholder engagement and responsible stewardship.

While ESG policies were previously a “nice to have” addition for managers, today they must have appropriate policies and programmes in place for both investment and business practices. On our platform, ESG policy adoption has increased to over 90 per cent, and we have a proprietary ESG integration framework by which we assess managers. For environmental factors, materiality varies across manager types (for example, sophisticated quant managers with heavy data usage are likely to have higher levels of energy consumption), while the relevance of climate-related risks to investment managers is generally quite low versus other types of companies. We view governance as being about having strong procedures, controls and oversight in place to monitor the business, including compliance programmes, audit timing, segregation of duties, valuation and cash movement.

On social criteria, diversity is a focus and a top priority – we believe both diversity of talent and thought can help enhance investment returns. Over the past two years, we have met with nearly 100 diverse managers (nearly half have been run by women), to help broaden the platform’s impact on diversity in the hedge fund industry. We track diversity in our propriety database and 26 per cent of JPMAAM capital is invested in diverse managers. We require a diverse slate of candidates for all manager searches and have a 50 per cent diversity goal when investing in emerging managers.

We believe the exponential growth in relevant data is the future of ESG investing. This will increasingly come from both standardised data that issuers will be required to disclose, and the unstructured data that will increasingly reference ESG. As reporting becomes more standardised and data becomes more readily available, we should start to see a proliferation of sustainable offerings from macro, quant and multi-strategy hedge funds, in addition to the long only and long/short strategies we’re primarily seeing today.

In Europe, we will start to see the effects of standardisation among regulatory bodies. SFDR is also laying the groundwork for how asset managers will apply sustainability in the US. Multiple markets in Asia are also implementing ESG reporting regulations for issuers and asset managers, particularly with regard to climate-related risks. We are already beginning to see this with the initiation of TCFD-aligned reporting standards in Singapore and Hong Kong. While ESG rules and regulations can help to provide guidelines for issuers and asset managers, without standardisation, there is potential for investor confusion.

Pete Keliuotis, Executive Vice President and Head of Alternatives Consulting, Callan

There’s certainly more interest in ESG; we’ve seen that growth for years and, originally, it was more focused on the traditional side of the market. Now, ESG considerations affect all asset classes and client types. Callan has regularly worked with clients to help them identify managers whose investment practices are consistent with their ESG policies, whether that means having more of an exclusionary screening, or having more impact-oriented investment strategies. So, we’ve witnessed a growth of interest there.

Within private equity we have seen widespread adoption of ESG factors as investment considerations for several years now, particularly by larger managers. And in real assets we’ve seen expanded investment in renewables and use of green building technology. However, until recently, adoption of ESG practices by hedge fund managers had been modest. But, in the past several months we’ve seen growth in impact-oriented strategies offered by hedge fund managers. One example is activist investors targeting integrated oil companies to try to persuade them to pivot towards renewables.

Some of our clients are interested in ESG integration at multiple levels: not just how these strategies are implemented at the portfolio company level, but also in understanding what a GP has done at the management company level.

We have an ESG consulting practice led by Tom Shingler and comprised of senior consultants and research professionals across the firm that work with Callan clients to create and implement customised ESG policies and procedures, as appropriate for their goals and governance, and to develop a strategy to implement these policies. Also, Callan is a PRI signatory, and we’ve instituted ESG practices within the organisation and as a result of our manager relationships.

Finally, DEI (diversity, equity, and inclusion) is an area of increased emphasis by Callan, its clients and its managers. We have revamped our efforts to promote DEI within the organisation, train our employees, and step-up recruitment of diverse candidates in hiring. With respect to managers and strategies, we have expanded our data collection efforts to better measure changes and compare firms and have increased the inclusion of diverse firms in our manager searches.

Geordie Cox, Investment Manager, Cardano

Hedge funds have been slower to demonstrate integration of ESG considerations into investment decision-making. Often citing a lack of relevancy, robust data sets and the costs of reporting. There has also, in our view, been a lack of understanding as to what ESG actually means from an investment perspective. Often, we find managers are considering these factors in investments (eg governance), but have not historically seen this as “ESG”.

We comprehensively rate over 160 strategies (including equity long only, fixed income, hedge funds and private market funds). Our research shows the above referred to pace of change improving. Ninety-five per cent of the managers we analysed (including hedge funds) demonstrated positive momentum on ESG issues. Positive behaviours included a growing willingness to engage, more robust ESG selection processes, increased use of data analytics and dedicated sustainability resources. But there remains more to be done; in particular, we would like to see further attention paid to stewardship (where the strategy allows).

We expect this positive momentum to continue. The more advanced hedge funds are already active in this space – increasing commentary/ reporting, as well as incorporating ESG data analytics and signals into their investment models and analysis. We expect this to continue to be driven by: (i) LP sentiment – it will be easier to raise if managers are meeting LP ESG demands; but also (ii) fundamentals – GPs are increasingly seeing markets (pricing/ volatility) affected by ESG factors.

Our personal approach is asset class specific – for ‘high focus’ strategies where ESG issues can affect the risk-return within the given strategy, we engage with managers to drive better practice. However, we acknowledge that in certain ‘low focus’ strategies (e.g. portfolios with synthetic exposure, low concentration, high position turnover etc.), ESG issues may be less relevant, and we would expect to see sustainability progress to be slower. We classify most (but not all) hedge funds as low focus, meaning we view ESG factors as having less impact on risk-return in the given strategy than in (for example) a buy and hold equity long only strategy with physical positions.

That said, minimum standards apply to all funds – we do not expect stagnancy within hedge funds. There is plenty of opportunity to advance. Our deputy CIO – Keith Guthrie – is co-chair of the IIGGC Hedge Funds & Derivatives working group, focusing on setting clear ESG targets and clarifying consultants’ expectations for hedge funds. The group is also looking at how hedge funds and derivatives positions can still achieve real-world sustainability impact, which in our view is an area less well-understood and considered.

Allocators are focused on improving hedge fund ESG practices. This is not a fad. Managers will need to evolve, regardless of their strategy focus. The best ones are already doing so.

For us the future of ESG investing falls into a few core themes.

The first – engagement – will become an intrinsic part of asset management services, as ESG data consistency and availability improves. We expect outsourcing to specialised engagement service providers (aggregating investor positions to maximise engagement agendas on behalf of investors) to be a growing trend. 

Secondly, ESG data (and analytics to process) will become ubiquitous in fundamental company/portfolio analysis. Data providers will continue to grow in importance, but consolidation of data, as well as cross-industry/asset class initiatives such as carbon accounting will increasingly be critical.

Thirdly, allocators will begin to look beyond seeing sustainability purely as a risk management tool and increasingly focus on the potential positive societal or environmental impact their portfolios could have.

This final bullet is best expressed (albeit by no means exclusively) in our client’s private portfolios, where the increased ability to control and the increased duration that private market strategies offer, provide one of the most powerful toolkits to drive real world impact.

Where public markets lead, private markets tend to follow, so we welcome the extension of TCFD reporting requirements and transition plans to private companies. We also expect to see more attention to sustainability impact disclosures, particularly where private funds are badged sustainable. The FCA is currently consulting on sustainability disclosure requirements and investment labels. The disclosures are expected to refer to the UK green taxonomy, which is also in progress.

Edward Lees and Ulrik Fugmann, Co-Head of Environmental Strategies Group, BNP Paribas Asset Management

We think interest will continue to grow for ESG among hedge fund managers and investors in 2022. More investors want ESG disclosure, and this is driving continued adoption of ESG policies across the industry. There is no reason to think this will reverse. As an indicator, ESG-themed ETFs had strong inflows over 2021.

The key themes across the space are easier to articulate for the “E” than for the “S” or “G”. There remain renewables (solar and wind), EVs, batteries, and various parts of the water industry. Interest is growing in hydrogen, smart meters/grid, relevant software applications, recycling, and biodegradable or less toxic products.

Ongoing political activity will help to drive interest in ESG in 2022. We are seeing the implementation of various net zero policies across the globe, including the European Fit for 55. This creates investment opportunities and helps to spur ESG momentum. As an example, the EU recently released its Gas Markets and Hydrogen Package, which puts forward legislative proposals to limit methane emissions linked to fossil fuel imports and sets rules for hydrogen to be used in European pipelines.

While US environmental policy has hit a stumbling block in Senator Manchin, do not suppose that the discussions in Washington are over. The rest of the Democratic party are discussing ways to break the impasse using executive action or breaking the bill into several pieces. Further momentum is likely to come from weather events. Weather, in any given year, is hard to predict, but we know the trend is one of warming that causes more intense storms. Just look at the recent tornados in Kentucky that killed over 70 people and caused significant damage. More of this will come, which will increase popular support for conscientious investing. This is especially prevalent in younger generations who next year will all be a little bit older, with a little more money and influence.

Lilly Knight, Co-Head of Investment Management, K2 Advisors

Historically, ESG investors excluded hedge funds from their asset allocations, as there were few ESG solutions available in the hedge fund universe. We acknowledge that the best practices of ESG integration are still evolving across hedge fund strategies, and indeed all strategies. As a result, we partner with our hedge fund managers as they develop their approaches, rather than prescribe any one singular approach. Our ESG philosophy and long history of responsible investing is grounded in understanding how our approved managers incorporate ESG and DEI considerations within their investment process and across their management company.

Our engagement with hedge fund managers focuses on stewardship and education, with a goal of evolving manager ESG processes, to increase sustainability awareness and appropriate implementation, and to advance the entire hedge fund community along the ESG spectrum. Our investment and operational due diligence teams act as stewards of the assets entrusted to us, and we use our influence to engage constructively with our underlying managers in an open dialogue about ESG philosophies, methodologies, and best practices.

As part of our work in stewardship, one of the aspects K2 measures over time with respect to individual hedge fund managers is ESG momentum and improvement. We believe that our role as a steward is to educate managers and help them generate and demonstrate positive momentum, or continuous improvement, in their ESG practices.

We recognise that ESG approaches and solutions will vary by client, manager, and strategy. Our purpose is to assess the intentionality, applicability, and quality of the given ESG approach to add value to our investments. We believe that, in time, ESG will not be looked at as a separate investment factor, but instead will be a routine part of the range of tools and processes the industry applies in analysing companies and managers.

We construct tailored portfolios of hedge funds that seek to meet investors’ investment risk and return objectives, but also their differing ESG objectives. Utilising position level or holdings-based transparency where applicable, our ‘ESG 360° Dashboard’ marries traditional ESG scoring metrics with attribution analysis, providing us with a holistic view of their hedge fund investment through an ESG lens.

ESG advancements within the hedge fund industry are being recognised at a time when the outlook for hedge funds is constructive. With elevated equity valuations and bond portfolios not providing the protection that they have historically, hedge funds may be an attractive
alternative for investors to consider.

When considering the evolving investor appetite for hedge funds over the next year, we see two types of investors. First, the long-term ESG committed investors who historically may not have considered hedge funds as part of their ESG portfolios. This was because, as an asset class, hedge funds lacked transparency and the complexity of the instruments challenged ESG analytics, which historically were designed around long only investing. Second, a younger wave of investors who themselves are new to the ESG investing landscape and are demanding more responsible solutions. Both groups are quickly recognising that ESG investing can now be tailored around hedge fund portfolios.

James Jampel, Founder, Co-CIO, HITE Hedge Asset Management

In 2021, popular culture charged into finance and subsumed many of the old rules. Memes, star power, and a grip on the imagination crushed many hedge fund shorts. On the long side, SPACs provided access to ventures that would normally only be available in private markets.

Since the “E” in ESG refers to an existential risk to the planet, along with potential for huge growth, it’s not surprising that environmental investing has been caught up in the mania. Given that maintaining a robust short book is what distinguishes hedge funds from their riskier long-biased cousins, managing that mania will continue to be a key to success, with certain valuations reminiscent of Internet 2000.

A key challenge for hedge fund short books is that they do not fit neatly into recent ESG constructs, like ‘carbon footprint’ and ‘impact’. Accounting logic demands that if a specific long book has a positive carbon footprint and suggests complicity of some kind, then an identical short book must have the same, but negative, carbon footprint and negative complicity. Similarly, if divesting a long position is deemed to have an impact by increasing a company’s cost of capital, borrowing a position and selling it must also have an impact by increasing the cost of capital.

Regulatory bodies and investment consultants, who are overwhelmingly concerned with long-only portfolios, are grappling with the implications of the above truisms. One of those implications is that a market neutral hedge fund that was short heavy carbon emitters could even claim a net negative carbon footprint, allowing it to shoot up the rankings, and potentially gain assets. It may not seem fair that a hedge fund doesn’t have to go through the potentially painful process of assessing every long holding when it can achieve carbon neutrality instead by shorting, which is something they do anyway.

Lastly, consider a hedge fund that is levered long and using its voting power to agitate for change among bad actors and laggards. Would we not want the regulators and consultants to encourage such a strategy? Without allowing shorts to count against carbon footprints, how could such a strategy pass muster?

So, a key issue for hedge funds in 2022 is to ensure that their distinguishing characteristic – the ability to short – is recognised as a potential force for good by those that heavily influence allocations. The last thing we want to do is penalise engaged but properly hedged investors by assigning them large carbon footprints because we are unable to count offsetting shorts.

Sean Trager, SVP, Advanced Clearing and Prime Services, Wedbush Securities

The Covid-19 pandemic reshaped the investment landscape. The hardships we faced as human beings (as well as investment managers) forced us to consider our long-term viability as a species. Health, safety and sustainability are now considered like never before when deploying capital.

We found that investment dollars, in many cases, facilitated growth and change on a global scale, and more specifically that we could change the world in a way that awareness alone could not. Family offices, endowments and institutional investors alike, care about where their money is being spent and how it impacts our respective futures. The volatility faced over the last two years is like nothing Wedbush has ever seen before. That said, whereas we once largely considered alpha and potential draw downs, we now consider the larger impact on our world. The appetite for enacting change socially, environmentally and otherwise is now a paramount component to marketability.

It is unlikely that anyone can predict the future of ESG investment, but we imagine that we will see hedge funds facilitating much of the change that banks do not. It might be an obscure biotech company farming shrimp that saves our oceans by helping minimise the need for commercial fishing, for example. Agribusiness alone could steer us away from the rocks in combating global warming and pollution.

A unified front between politicians, practitioners and regulators will allow for growth in the ESG space. That growth will impact us as people in ways Wall Street never has. Using our capital to alter the course of history through human rights initiatives, farming, carbon emissions, and biotech will make Wall Street more effective than most non-profit organisations.

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