How ESG hedge funds keep the environment in mind

Over the past few years, looking after the environment and tackling climate change has become a key concern for many people across the globe. As such, more institutional investors are choosing to support companies that have a positive impact on the planet and society as a whole.

In fact, as more of the world’s wealth is transferred to millennials – who are widely regarded to be more conscientious of environmental and social issues than previous generations – many younger investors are making financial decisions that reflect their ideals, which is often referred to as ‘impact investing’.

A 2020 report by The Forum for Sustainable and Responsible Investment (US SIF) found that in the US alone ‘sustainable investing strategies grew from $12 trillion at the start of 2018 to $17.1 trillion at the start of 2020, an increase of 42%.’ The same report also found that ‘environmental criteria as a whole grew faster than social or governance factors over the past two years, increasing 57%, from $10.1 trillion to nearly $16.0 trillion.’

While it’s clear that socially responsible investing continues to grow in popularity among individual investors, a lot of research and due diligence is needed when searching for ethical companies with good growth prospects. This is where ESG hedge funds come in. But what is an ESG hedge fund and what makes them different to traditional hedge funds?

What is ESG?

‘ESG’ stands for environmental, social and corporate governance – key factors by which to measure the sustainability and social impact of an investment. This means that ESG hedge funds will not only exclude the likes of oil and gas companies, tobacco manufacturers and defence contractors from their portfolios, but will only consider buying shares in ‘good’ companies. Generally speaking, this would include companies that have a low carbon footprint, treat their staff fairly, support social justice and generally strive to have a positive impact on the world. On the other hand, companies operating in controversial countries may be excluded from ESG funds.

Of course, like any investment firm, ESG hedge funds value (and their clients expect) returns. However, what makes them different to traditional hedge funds is that profit is generally less important than supporting companies that fit a fund’s (and its clients’) moral values.

How do ESG hedge funds choose environmental stocks?

When considering which companies to include in their portfolio, ESG hedge funds look at a broad range of business practices and behaviours. While some investors may be more concerned about social issues or how a company conducts its business, when it comes to assessing the environmental impact of an organisation, ESG investors are likely to look at a company’s energy consumption, pollution, conservation of natural resources and their stance on animal welfare.

On the surface these criteria may appear to prioritise ethical and ideological concerns, but they could also shine a light on potential financial risks that other non-ESG investors may fail to consider.

The benefits of ESG investing

As ESG criteria essentially limit the number of potential companies a hedge fund can invest in, it was initially thought that a socially responsible investment plan would inhibit a fund’s potential to turn a profit. While ESG hedge funds were making conscientious investment decisions, traditional hedge funds could make considerable returns from companies that didn’t meet ESG criteria.

More recently, however, many socially and environmentally responsible investors have come to the conclusion that ESG criteria are more practical than previously thought. For instance, issues around ownership of contaminated land, toxic waste disposal, emissions control and compliance with environmental regulation could all prove to be significant risks to the future performance of a company’s stock.

By avoiding non-ESG compliant companies, hedge funds put themselves in a position to mitigate risks that could have an adverse effect on a company’s stock in the future. For example, the portfolios of environmentally responsible hedge funds are less likely to have been shaken by scandals in major companies as others have been.

Not only do impact investors benefit from the comfort of knowing their money is being put to genuinely good use, but their portfolios are hedging against the risk of potentially scandalous business practices, which could harm their investment later down the line.

Human rights and ESG

Due to the environmental and social effect that organisations have on the world, many ESG investors are becoming increasingly wary of investing in hedge funds that have dealings with countries running contentious regimes.

While many activists are calling for large hedge funds and investment banks to stop buying government bonds from countries with questionable human rights records, fund managers are insisting that knowing whether or not to buy government bonds from a particular country isn’t easy.

‘We have a core responsibility to generate a return for investors,’ Timothy Ash, senior emerging market sovereign strategist at BlueBay told The Financial Times. ‘And a lot of the challenging ESG stories (countries ranking poorly on environmental or social measures) have the (highest) yields, which obviously creates a bias to invest.’

While this may be a complex matter, ESG investing is evolving and as time goes on such factors are likely to be given more consideration. For example, new EU legislation pegged to be implemented in 2023, will require fund managers to provide more information regarding the countries they lend money to and their human rights records. This will give investors more transparency as to where their money is going.

With more transparency investors should be able to make more informed decisions about where to invest their capital, which in turn enables them to make up their own minds about how ESG-tight they’d like their investments to be.

Are environmentally conscious investments the future of finance?

ESG investment plans have grown significantly in popularity over the past decade and logic would suggest that this trend will continue as environmental issues, such as climate change and plastic pollution, are among the greatest concerns of a generation. So, despite the fact that fossil fuels like crude oil and natural gas are the most traded commodities on the market, the majority of hedge fund managers understand the importance of ESG and will look to increase their ESG commitments in future.

As found in our eco-conscious investors report there are a number of industries on the rise for those who are wanting to be socially responsible when investing, with the likes of machinery and The Weir Group showing some of the best performing stocks in the industry.

Depending on one’s perspective, this may suggest that impact investing remains a relatively untapped market, especially given that the transfer of wealth to millennials is still underway. But whether future market trends will further push the popularity of renewable energy providers and other environmentally and socially focused companies is yet to be seen.