The Winding Road to Sustainable and Responsible Hedge Fund Investing
Erik Eidolf & Marcel Herbst
Sustainable and responsible investing (SRI) is rapidly making significant inroads into the mainstream investment world. Once considered a cottage industry primarily catering to a small set of faith-based investors, today approximately US$7 trillion of assets1 are managed within the context of sustainable investing. Investors, be they individual or institutional, view SRI investing no longer as an exercise in altruism, but rather as a valid means to generate superior performance. The alternative investment industry has started to offer SRI solutions as well. In our view, hedge funds are particularly suited for SRI investing. They tend to be very active investors and able to quickly adapt to changing markets. Therefore, they are also suited to embrace SRI in their investment practices. With this article, we highlight the most recent developments within the hedge fund industry related to SRI and provide our best guess as to what the future holds.
SRI Investing: A Short Primer
SRI refers to the investment concept that seeks to integrate extra financial criteria [often referred to as environmental, social and governance (ESG) issues] in the investment decision process and portfolio management2. There are multiple ways in which investors interpret and implement SRI, but there are four major approaches commonly used within the context of sustainable investing:
Positive screening is the process of active investing in companies with a commitment to sustainable and responsible business practices. The most popular form of positive screening is the so-called best in class strategy, where leading companies with regard to ESG risks or other related criteria in each sector/industry are identified and included in the portfolio. Another form of positive screening is the so-called pioneer screening, where investments are focused on certain themes such as renewable energy or improved water supply.
Negative screening is the process of exclusion. It consists of barring investments in certain companies, sectors or countries based on ESG risks or other related criteria. Investors will primarily use negative screening to avoid a specific exposure in the portfolio. The criteria screened range from specific sectors such as weapons, alcohol, tobacco, gambling etc, to a norm-based/ethical screening focused on companies’ compliance to international conventions.
Engagement is primarily a post-investment tool. It is the collective term for a number of actions that can be taken to influence companies as an active owner. Traditionally, ownership-engagement has been mostly used in corporate governance matters. Nowadays, more responsible investors are engaging in corporate dialogue to influence behaviour across social, environmental and ethical topics. Engagement includes anything from dialoguing with management on areas of concern to filing, co-filing and voting on shareholder resolutions. The proxy resolutions generally aim to improve company practices on ESG issues in order to achieve positive change to create sustainable long-term performance and shareholder value.
Integration is the approach whereby the investor seeks to fully integrate ESG issues into the investment decision process. Often, the investor uses SRI as a key input in developing the investment strategy and thereby, actively seeks to generate returns by exploiting SRI risks and opportunities in parallel, or integrating them into company valuation.
SRI investing has witnessed substantial growth in recent years3. A growing global population, increased globalisation and resource consumption at a rate far surpassing long-term capacity have supported this trend.
Companies are realising that incorporating SRI issues in their business activities has clear benefits as evidenced by the globally large support the UN Global Compact initiative has, in which companies commit to aligning their business activities within the areas of human rights, labour, environment and anti-corruption. The UN Global Compact is an initiative that since its launch in 2000 has grown to more than 5,200 corporate members in 130 countries around the world4. Similarly, the Carbon Disclosure Project, an independent not-for-profit organisation also incepted in 2000, which holds the largest database of corporate climate change information in the world, retrieves data from more than 3,700 companies across the globe5. These developments reflect that SRI issues are indeed something real and tangible for most corporations globally.
As a response to this, annually-audited financial reports go hand-in-hand for most companies with issuing sustainability reports as to how they deal with SRI issues. This is a means to enhance their ability to attract long-term investment and to better manage their level of overall enterprise risk. Considering that SRI is often seen as a sign of good management, it therefore has a direct impact on how these companies are valued by the capital markets. This integrated valuation approach is set to accelerate going forward.
With this in mind, hedge funds, being at the forefront of the financial market innovation and by nature being active owners, are perfectly placed to embrace these SRI considerations as part of their investment practices.
Hedge Funds, Meet SRI
While 2008 has been a difficult year for hedge funds, the industry today has very much stabilised and currently manages approximately US$1.4 trillion6. In fact, assets are growing again and performance has met or exceeded expectations. As the industry moves into the next phase of its development, we believe that offering SRI solutions will be one way for hedge funds to set themselves apart from the competition. SRI presents new opportunities, and hedge funds will seek to seize them.
Hedge funds are suited for SRI investing because the challenges posed by the effects of globalisation and resource scarcity are drastically changing the flows of capital and the structure in which the capital flows. Hedge funds look to anticipate catalysts of change and aim to profit from perceived inefficiencies.
There is also a demand side element to the future growth of SRI in hedge fund context. As institutional investors across the globe are increasingly incorporating SRI, as evidenced by the success of UN PRI having since 2006 grown from 50 to 570 signatories representing US$18 trillion of assets and 36 countries7, these investors will require the ability to express their SRI requirements across all their investments, which includes hedge funds. However, especially the large institutional SRI investors struggle to find a sufficient quantity of hedge funds able to offer SRI-compliant solutions in scale. This has, until very recently, meant that these investors for the interim opted to go for non-compliant hedge fund solutions, or forego an investment altogether. This is changing, and we are proud to play an active role in this development through Harcourt’s SRI initiative launched in 20078.
There is a variety of ways in which SRI can be implemented in hedge fund context. Thematic initiatives, such as renewable energy, clean water, etc, have their logic and merits from an SRI perspective. The pitfall from a sustainability aspect is, however, that they are much less expansive, as sustainability in its broadest term seeks to also incorporate other aspects such as human rights, broader environment risks, corruption etc. One challenge for SRI investors into thematic funds is that the SRI theme can be interpreted in many different ways, so if one invests in a portfolio of such thematic funds, you might be exposed to risks that you do not necessarily want as an SRI investor.
Growing Pains: Learn From The Past
The SRI industry is growing and as with anything, this is associated with growing pains. Looking at the development phase of SRI today, we can draw parallels to the development of the hedge fund industry from the late-1990s until today. Lessons can be learnt.
About ten years ago, hedge funds were still relatively non-transparent. A limited number of funds, unknown to the larger investment industry, operated very diverse strategies in opaque ways. Nobody really knew how to define hedge funds; their only commonality being the “2 & 20” fee structure. Hedge funds were primarily a wealth creation vehicle for high net worth individuals.
Around that time, recognising that most institutional investors in search for absolute returns would be unlikely to invest directly into hedge funds, funds of hedge funds were created. Not only did funds of hedge fund firms provide a diversified and educated way to access hedge funds, they also were big proponents of education and knowledge transfer to these investors.
The SRI world is similarly opaque and complex. In addition, applying SRI tenets means a paradigm change, as they are less tangible and measurable than quantitative financial data. The complexity becomes exacerbated as many market practitioners still limit the disclosure of their SRI policies and procedures. As there are multiple approaches to express SRI, combined with a lack of a commonly and generally accepted definition of SRI, the SRI industry is naturally prone to misconceptions and misunderstandings by market participants.
We see the following analogies to the olden days of hedge funds:
The lack of understanding
One of the key challenges that the SRI industry has been faced with is the lack of uniform understanding as to how SRI is defined and expressed. Extra-financial information is rather subjective in nature and there are very different degrees as to how SRI issues can be implemented. We do see some signs of harmonisation of SRI approaches and policies. However, these developments need much more attention by market participants to fully support the trend of increased awareness of SRI issues in the capital markets. We believe that the SRI practitioners should take much larger responsibility in these regards and more proactively disclose their SRI policies and procedures.
The lack of transparency
SRI practitioners we find today most often still do not want to disclose in detail how they incorporate SRI in their business. There is considerable hesitation among some SRI practitioners to be transparent about their SRI procedures with the fear that it could impose a commercial and competitive disadvantage in doing so, ie by being copied by others. As SRI continues to grow in importance and in awareness, disclosure is, however, more likely to become a means for competitive advantage as full disclosure not only increases the understanding of SRI implementation in general but on a comparative basis, merits the most serious practitioners in particular.
The lack of a common definition
With the ever-lingering problem of SRI not having a commonly accepted definition, there is a chicken-and-egg problem related to creating standardised SRI solutions which is hampering the possibility for asset managers to create uniform SRI solutions. But with initiatives such as UN PRI, where SRI investors join forces and actively share views, this process is facilitated. There is still a long way to go before a standardised framework is defined in the SRI industry.
SRI In Hedge Fund Context – How Is It Done In Practice?
There are two main approaches for hedge funds to integrate SRI criteria into their investment strategy. Either the hedge fund can adjust its standard investment strategy by limiting its exposure to a (predefined) list of approved SRI-compliant instruments, or the hedge fund can use SRI criteria as input into taking long and short positions in instruments based on how well SRI is reflected or will be reflected in the value of such instruments.
In the first approach, the manager seeks to utilise his/her skills in employing a certain hedge fund strategy whilst constraining the exposures to an SRI-compliant list of instruments. The hedge fund will need to assess whether the approved list of instruments enables the manager to utilise the same type of investment strategy and investment philosophy despite the constrained universe. As hedge funds, unlike traditional long-only funds are able to go short, they are often more flexible and able to express the same strategy in a limited universe of instruments. The critical aspect for the SRI investor is to assess the manager skill of the hedge fund as well as how well the hedge fund can manage the portfolio using the same investment approach, but within the constrained universe of instruments. One major benefit for the SRI investor to this approach is that it is not intended for the hedge fund to change its investment approach (eg incorporating SRI criteria in valuations of instruments) but that the investor instead, at all times, will solely be exposed to instruments deemed SRI-compliant. This makes it easier for the hedge fund to embrace SRI as it is based on an existing investment process for which the hedge fund has a proven track record.
The second approach requires the hedge fund manager to fully integrate SRI criteria into the investment approach. As such, the hedge fund will use SRI input in evaluating instruments and use SRI criteria as catalyst for going long good/sustainable companies and going short bad/unsustainable companies. This approach is likely to become more commonplace in the future as SRI issues are increasingly being reflected in how the financial markets are evaluating instruments. This approach is, however likely to be more volatile than the constrained universe approach as SRI is not the sole catalyst for valuation changes of instruments9. It is in our experience possible to successfully incorporate SRI criteria in virtually any type of hedge fund strategy. As hedge funds are flexible and active investors, they have the necessary prerequisites to amend their investment philosophies to either limit their exposures to companies that are deemed not to be in conflict to sustainable business practices or actively use SRI issues as (new sets of) catalysts for valuating companies in their portfolio management.
Performance Effects Of Incorporating SRI In Hedge Fund Context
The key issue for hedge fund manager is whether incorporating SRI into an existing investment strategy will put limitations to the risk and return objectives. In other words, all else being equal, SRI has to perform as well as non-SRI. One common critique to SRI is that the limitation to the investable universe will hamper the possibility for return generation. This issue has been subjected to many academic studies and most often, they come to the conclusion that it is rather manager skills and investment style that ultimately determines the performance effects of incorporating SRI10. As this goes hand-in-hand with manager skill being one of the most crucial aspects for a successful hedge fund, we believe that truly skilled hedge fund managers, who create vehicles that incorporate SRI, will prevail.
A major benefit of the scope of SRI increasingly expanding is that the SRI-screened and SRI-approved universes today often are extensive, which provides a tradable SRI-compliant universe of companies with big diversity within. A large tradable universe has a higher likelihood to enable hedge funds to express their strategy in an SRI-compliant context without hurting performance.
Anecdotally, Harcourt has found that limiting the universe has little impact on the performance-generating capability of hedge funds. Our SRI-compliant fund of funds is currently invested within approximately 25 managers, who are constrained from investing with approximately 600 out of 3000 companies globally. These 600 companies have been eliminated on the basis of human rights, corruption, environment, or business sectors which are not consistent in an SRI context. Not only have we found no evidence of a negative performance impact, rather, the fund outperformed average hedge fund returns dramatically in the difficult year of 2008.
The Future Unfolds
We believe that the SRI movement has already begun, and that its positive prospects for further growth are substantiated by the current developments. The ever-growing demand will encourage product providers to develop new and diverse SRI solutions suitable to a wide range of investors.
As SRI investing continues to grow, it is about to reach a juncture in size that will afford it an important and prominent role in the overall investment industry. The alternative investment industry, initially slow to provide SRI-compliant solutions, is catching up. Amidst a backdrop of a difficult asset raising environment and in response to the changing needs of the investors to incorporate SRI considerations, hedge funds in particular are beginning to view the ability to provide SRI solutions as a competitive advantage and are doing so in increasing numbers.
In addition and perhaps most importantly, as the current developments within the concepts of sustainable hedge fund investing show, blending the philosophies of SRI and hedge fund investing is not only possible and plausible, but indicates that it may provide new means to provide superior investment performance in the future.
For SRI to be even more broadly embraced by the hedge fund industry, increased understanding of the concepts of SRI and the diverse ways SRI issues impact the value of a portfolio are still needed. With further visibility on the specific needs of SRI-focused asset owners, we are convinced that the hedge fund industry will be able to cater to these needs. The winding road to get there relies heavily on continued and intensified knowledge-sharing and collaborations between practitioners of SRI, hedge funds and investors alike.
1European Social Investment Forum (EuroSIF), “European SRI Study - Global SRI Data”, October 2008.
2For further details on the concept of SRI investing, please refer to swissHEDGE Q3 2007 and swissHEDGE Q1 2009 issues.
3The European Social Investment Forum’s (EuroSIF) latest bi-annual report on SRI-related assets under management in Europe states an overall asset estimate of EUR2.7 trillion as of 31 December 2007. This corresponds to a remarkable growth of 102% since 31 December 2005.
6Hedge Fund Research Inc, “HFR Global Hedge Fund Industry Report – Second Quarter 2009”, July 2009.
7UNEP Finance Initiative, “Annual Report of the PRI initiative 2009”, June 2009.
8Harcourt, together with the two large European SRI investors Folksam/KPA of Sweden and Storebrand of Norway, established the first institutional SRI-compliant fund of hedge funds by the launch of Belair (Lux) Sustainable Alternatives SRI Fund in November 2007.
9There is an ongoing debate among some SRI practitioners whether shorting unsustainable companies is a viable SRI strategy. Harcourt is of the opinion that there are definitely approaches under which shorting certain stocks or sectors can be deemed sustainable. However, shorting may have both positive and negative effects from and SRI perspective. On the positive side shorting implies selling pressure which would increase the refinancing costs of a non-sustainable company. This could force such a company to change its behaviour. On the other hand, shorting leads to better liquidity, smaller bid-ask-spreads and therefore lower transactions costs. This most often leads to lower refinancing costs and the non-sustainable company would not be forced to change its behaviour. Therefore shorting as a means to punish a company is far less effective (and in most occasions could lead to the opposite) than direct corporate engagement to seek to improve the business practices of the unsustainable company.
10UNEP Finance Initiative/Mercer, “Demystifying Responsible Investment Performance”, October 2007.