Research

The hedge fund ESG experience: the rise of conscientious and responsible alternative investing

Investors are increasingly beginning to incorporate ethical considerations into their investment decisions, a development which has given rise to the ESG framework over the years. Despite the implementation challenges which arise when screening investments against acceptable environmental, social and corporate governance themes, the trend towards a more conscientious approach to investment is here to stay, especially from the perspective of large institutional investors. Fund managers, for both actively and passively managed investment vehicles are balancing their quest for superior returns with the need to meet investor demand for responsible investing. Further, an understanding that such an approach to investment can translate into ‘ESG induced alpha’ for managers is further helping the cause of ethically guided investing. This article looks at the performance of funds, both long-only absolute return vehicles and hedge funds, with an active ESG investment framework and how they have performed over the years.

The Eurekahedge ESG Fund Index, which tracks the performance of 771 fund managers who incorporate an ESG framework in their investment process was down 2.02% as of June 2018 year-to-date. This compares with the -2.15%, -0.66% and 0.63% returns of the MSCI ACWI ESG LEADERS Index, the Eurekahedge Islamic Fund Equity Index2 and the custom Eurekahedge Equity ex-ESG Fund Index3. Meanwhile, the average global hedge fund has posted a small gain of 0.08% over the same period. ESG fund managers closed 2017 with a 12.61% gain on average, outperforming the 8.59% return posted by the Eurekahedge Islamic Fund Equity Index over the year, but still trailing behind the performance of ESG equities as represented by the MSCI ACWI ESG LEADERS Index which edged 20.67% higher on the back of the 2017 equity market rally.

Figure 1 below depicts the performance of the Eurekahedge ESG Fund Index versus comparable benchmarks since the end of 2007. Over the period depicted, the ESG fund managers tracked by the Eurekahedge database have generated an average annualised return of 3.81%, ahead of Islamic equity funds and the global ESG equities which gained 1.75% and 2.63% respectively. On the other hand, ESG fund managers underperformed their non-ESG peers utilising long short equities strategy which returned 5.10% per annum since the end of 2007. However, looking at the post-crisis period starting from the end of 2008, ESG fund managers managed to generate an annualised return of 8.88%, leaving the Eurekahedge Equity ex-ESG Fund Index by more than 80 basis points over the same period.

Figure 1: The Eurekahedge ESG Fund Index performance since 2007
The Eurekahedge ESG Fund Index performance since 2007

Table 1: Performance in numbers – Eurekahedge ESG Fund Index vs comparable benchmarks

 
Eurekahedge ESG Fund Index
MSCI ACWI ESG LEADERS Index
Eurekahedge Islamic Fund Equity Index
Eurekahedge Equity ex-ESG Fund Index
2008
(34.02%)
(41.55%)
(39.64%)
(18.96%)
2009
35.63%
31.97%
29.00%
25.75%
2010
13.65%
10.43%
12.32%
10.93%
2011
(9.75%)
(8.41%)
(6.09%)
(5.97%)
2012
10.52%
12.42%
10.53%
8.48%
2013
12.41%
21.91%
16.62%
16.23%
2014
3.68%
2.80%
3.59%
3.61%
2015
3.63%
(4.15%)
(3.42%)
3.26%
2016
9.49%
5.54%
4.98%
3.68%
2017
12.61%
20.67%
8.59%
12.63%
2018 year-to-date
(2.02%)
(2.15%)
(0.66%)
0.63%
2 year annualised returns
7.99%
11.23%
6.80%
9.22%
2 year annualised volatility
3.68%
8.10%
4.49%
3.77%
2 year Sharpe Ratio (RFR=2%)
1.90
1.14
1.07
1.91
3 year annualised returns
5.61%
5.79%
1.89%
4.57%
3 year annualised volatility
4.64%
10.34%
7.66%
4.84%
3 year Sharpe Ratio (RFR=2%)
0.99
0.37
(0.01)
0.53
5 year annualised returns
6.83%
6.93%
4.39%
6.59%
5 year annualised volatility
5.66%
12.71%
8.52%
5.81%
5 year Sharpe Ratio (RFR=2%)
1.03
0.39
0.28
0.79

Source: Eurekahedge

Table 1 summarises the key performance statistics for the Eurekahedge ESG Fund Index relative to comparable benchmarks. Key takeaways include:

  1. ESG compliant funds in the Eurekahedge database have generated better annualised returns compared to Islamic equity funds over the last two, three, and five year periods (7.99%, 5.61%, and 6.83% respectively). However, they were trailing behind the MSCI ACWI ESG LEADERS Index which was designed to track the performance of companies with high ESG compliance.
  2. Non-ESG compliant equity funds outperformed the Eurekahedge ESG Fund Index over the last two years by returning 9.22% per annum. Over the longer three and five year periods, ESG compliant funds posted better returns.
  3. In terms of risk-adjusted performance, the Eurekahedge ESG Fund Index generated better Sharpe ratios over the two, three, and five year periods compared to the benchmark MSCI index and Islamic funds. Using a risk-free rate of 1%, ESG fund managers managed to post a Sharpe ratio of 1.90 over the last two years.
  4. Compared against their non-ESG peers, ESG compliant funds managed to post lower volatilities and marginally better annualised returns over the last three and five year periods. However, the losses incurred in the first half of 2018 allowed the Eurekahedge Equity ex-ESG Index to generate better annualised return and Sharpe ratio over the last two years.

Table 2 provides the correlation values between the performance of ESG fund managers against the benchmark indices and non-ESG equity fund managers.

Table 2: Correlation matrix

ESG funds correlation matrix

Source: Eurekahedge

Figure 2a and Figure 2b offer important insight into understanding the return drivers for the Eurekahedge ESG Fund Index. The first chart depicts the performance attribution for monthly returns based on regional mandate, whilst the second chart accomplishes the same based on strategy.

With reference to Figure 2a, the constituents of the Eurekahedge ESG Fund Index are sorted based on their regional exposure into three buckets: developed markets focus, emerging markets focus or a global mandate that spans across both. As the chart below reveals at a glance, emerging market mandated ESG funds feature heavily in the current index constituent base and have been the major factor influencing returns both on the upside as well as the downside. The implementation of ESG frameworks especially in marketing emerging market mandated funds to sophisticated overseas investors could potentially help add to the appeal for such funds especially in relation to themes such as sound corporate governance and social responsibility.

Figure 2a: ESG Fund performance attribution by regional mandate
ESG Fund performance attribution by regional mandate

Figure 2b provides the breakdown of the ESG index performance and divides the index constituents into two categories: hedge fund strategies and long-only absolute return strategies. As is evident below, funds utilising long-only absolute return strategies are key drivers of returns among the constituents of the Eurekahedge ESG Fund Index, indicating the tilt towards emerging market mandated long-only absolute return strategies within the ESG fund space. However, seemingly contradictory to this observation, roughly 75% of the current Eurekahedge ESG Fund Index utilised hedged strategies. This could be explained by the higher magnitude of the returns of long-only absolute return funds, driven by their higher volatilities compared to hedged strategies which employ short positions as exposure protections against the equity market returns.

Figure 2b: ESG fund performance attribution by strategic mandate
ESG fund performance attribution by strategic mandate

Over the last five years, the Eurekahedge ESG Fund Index has managed to generate excess returns over its benchmark indices, with alpha of 0.34% against the MSCI ACWI ESG LEADERS Index and 0.38% against the Eurekahedge Islamic Fund Equity Index. ESG fund managers have also delivered 0.12% alpha over their non-ESG competitors as represented by the Eurekahedge Equity ex-ESG Fund Index over the same period. This would signify that the additional research conducted by fund managers to determine the ESG compliance of their securities also helped them deliver superior performance, refuting the common misconception that ESG investing entails additional costs and inferior performance. Furthermore, incorporating ESG principles into the investment philosophy can help add another compelling dimension for hedge fund managers seeking institutional capital – especially when it does not add to fees or come at the expense of returns.

The full article inclusive of all charts and tables is available in The Eurekahedge Report accessible to paying subscribers only.

Subscribers may continue to login as usual to download the full report and non-subscribers may email database@eurekahedge.com to enquire on how to obtain the full research report


Footnote

1 Total 97 constituents include liquidated funds to adjust for survivorship bias
2 Islamic funds can be viewed as a subset of Socially Responsible Investment funds with slightly stricter ESG frameworks in some cases
3 TA custom index composed of long short equities hedge funds which excludes the constituents of the Eurekahedge ESG Fund Index
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