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What is ESG and why is it such a divisive issue for hedge fund managers?

ESG funds have been in the news a lot recently. Few investment managers would disagree with the notion that ESG funds can be a force for good. But many are concerned about recommending funds that are marketed with words like ‘ethical’ and ‘sustainable’ when the underlying data do not necessarily support such claims.

Construction yard machinery surrounding the sea Source: Bloomberg

ESG meaning for hedge fund managers

ESG (Environmental, Social and Corporate Governance) is a term used to evaluate a company's social and environmental impacts and the impact it has on communities, customers and its employees. However, it is not standardised, so interpretations can vary between different companies and legislatures.

Traditionally, ‘ethical’ funds were not always taken seriously by hedge fund managers and investment bankers. They were seen as something ‘vocational’ - a hobby or something good for PR.

But things have changed a lot over the last few years.

ESG investing is here to stay

There has been enormous growth in the amount of capital injected into these types of funds in recent years - with annual cash flow doubling from 2019 to 2020 alone. There has been a 25-fold increase in total assets held in sustainable investments, with positive quarterly growth occurring in 31 of 32 quarters up to summer 2021.

The two ways of ESG investing:

Investing in sustainable companies and retracting from those that are non-sustainable

Many ESG-conscious investors will prefer companies that take this approach, as it shows they are taking decisive action to move away from non-sustainable funds.

Remaining invested in non-sustainable companies by trying to divert to more-sustainable practices through voting

This may not be as popular with investors, but pragmatics may argue that it is a more realistic and practical pathway for companies that still rely heavily on products such as fossil fuels.

But there are concerns over the future of ESG investment funds

One of the perceived limitations with ESG funds is that there is a lack of standardisation - a universal set of principles/metrics with which investors can accurately judge how ethical a fund is in relation to others.

Why is this bad for hedge fund managers?

Without standardisation, reporting data to regulators consistently is a key challenge for hedge fund managers.

Last year, an umbrella group for securities regulators attempted to 'harmonise' ESG standards to help accelerate the growth of the green finance sector. The International Organization of Securities Commissions said it wanted to identify 'commonalities' to improve sustainability disclosure standards and make it easier for asset managers to get information on sustainability risk for their ESG investment strategies.

Paul Andrews, former secretary-general at IOSCO, even said he wondered if something akin to the International Reporting Standards could be worth pursuing for ESG funds.

But last year, the CFA Institute did reveal its first ESG disclosure standards – designed to help investors understand whether their prospective products align with their objectives. However, the Institute’s president and chief executive, Margaret Franklin, said that the ESG investing landscape was still 'vast' and that the industry needed to 'identify ways to mitigate greenwashing'.

Speaking in regard to the announcement of those new disclosure standards, Paul Andrews also stressed the need for a 'harmonised, global approach' to ESG matters that would 'enable investor protection'. As ESG funds and strategies continue to expand and sophisticate, these standards can help 'drive greater communication' between the buyers and sellers of investment products.

Not everyone is in favour of such uniformity

Malcolm McPartlin, Co-manager of the Aegon Global Sustainable Equity Fund at Aegon AM, says that while standardising quantifiable things - like how much carbon a company emits - is easy - standardising governance is more difficult.

McPartlin says that ESG is already a grey area - thanks to varying definitions across the industry - so he advocates for a more qualitative approach to analysing companies' ESG, rather than a quantitative approach from rating agencies, which he argues 'often misses the bigger picture'.

Millennials and Generation Z are also increasingly critical of companies’ ethical performance

It’s no longer enough to say to your customers ‘we care about the environment’, ‘we care about being sustainable’, ‘we’re doing our bit for the planet’.

Many retail investors - particularly those under 40 - want to see compelling evidence that companies can back up their ESG claims - and this will feed back to institutional investors and ESG hedge funds too.

And millennials and Gen Z are often just as concerned about ethical credentials as they are about returns.

And that’s not the only problem

For ESG risk management, some investors are nervous about recommending such funds - or describing them as ‘ethical’ and ‘sustainable’ - if there isn’t enough data to back up these claims. In fact, just because something is ‘sustainable’, doesn’t mean it’s ‘ethical’. For example, a fund may have links to agricultural practices in a developing country that may be ‘environmentally’ sustainable’, but workers may still not be receiving a wage that meets the minimum standards of Fairtrade, for example.

Scepticism of ESG is widespread

Even the former head of sustainable investing at BlackRock, Tariq Fancy4, believes that ESG is a 'distraction' by creating a placebo effect in which people think they're making progress when they're not. He argues that 'systematic government oversight' is the only 'scalable' solutions for climate change - and says that ESGs, even then 'marketed correctly' - have 'no demonstrable impact'.

In his annual letter, Blackrock CEO Larry Fink said pushing sustainability was not about being an environmentalist, but about being 'capitalists and fiduciaries to our clients'. Having previously described climate risk as an investment risk, he predicted that the next 1,000 ‘unicorns’ would be 'sustainable', 'scalable innovators' - not search engines or social media companies. They – along with established companies - can help the world decarbonise and ensure the transition to cleaner energy is affordable for all consumers.

In stark contrast, Stanford Social Innovation Review, meanwhile, made a bold claim that 'the world may be better off without ESG investing'.

And before jumping to the conclusions that they must somehow be opposed to environmental, social and corporate governance - their argument isn’t that ethics isn’t important. Quite the contrary, the author argues that the standard of good corporate governance is 'abysmally low'. This, he says, makes ESG investing 'the hottest trend in investing today' - but simultaneously a 'greater force for destabilising society' than if ESG ratings didn't exist at.

The author points out that some of the biggest companies in the tech sector - like Facebook and Google-owner Alphabet, tend to have the biggest holdings for ESG funds. That means these companies' ESG ratings are often more favourable - simply because their ESG funds have lower carbon footprints. But this is, evidently, an ineffective way to judge a company's true impact on the planet and people - and greenwashing is a huge problem right now.

What is greenwashing?

This refers to a company's attempt to deceive customers or clients into believing that their products/services are more environmentally friendly than they really are.

For example, the Harvard Law School Forum on Corporate Governance referred to a recent KMPG report revealed that some hedge fund managers may 'greenwash' because they lack the expertise and data on ESG, or they may be sceptical about it. Fund managers may also endorse the United Nations Principles for Responsible Investment (PRI) to attract responsible investors, without incorporating ESG investing themselves.

ESG has become a major trend in hedge fund management

In January 2022, Paul Tudor Jones, a billionaire and hedge fund trader who co-founded the ESG investing research firm Just Capital, said the best-performing companies focus on what he terms 'the most important metrics' - rather than purely on profits. That includes taking care of workers, addressing issues such as pay inequality, and other financial, economic and social issues.

In a Barclays survey published last year, 'value alignment' and investor preference' were the key drivers for hedge fund managers' decisions to incorporate ESG into their products. The majority (60% of ESG conscious investors said they would seed ESG-focused hedge fund products, especially if it is a well-known fund or for a particular product.

However, many hedge fund managers have vented frustration over a new European rule known as the Principle Adverse Impact (PAI) rule of the Sustainable Finance Disclosure Regulation - which requires their firms to confirm whether their investment activity may harm the environment. However, many hedge fund managers argue that this rule is obscure and has left hedge fund managers 'scratching their heads' and could even upend business models in this sector.

But the fact remains that ESG is becoming a key performance indicator for hedge fund managers – driven by investors who are more and more ethically conscious.

So how can hedge fund managers incorporate ESG into their funds more effectively?

In 2020, the PRI, in partnership with the UNEP Finance Initiative and UN Global Impact7, identified six principles for hedge funds to incorporate into ESG. This document is extensive - and an excellent read if you are interested in the more-technical aspects of ESG issues - but here is a summary of the six principles they have committed to:

  1. To incorporate ESG issues into investment analysis and decision-making.
  2. To be active owners and incorporate ESG issues into their ownership policies and practices.
  3. To get disclosure on ESG issues by entities they invest in.
  4. To promote wider adoption of these Principles in the investment industry.
  5. To collaborate on enhancing the effectiveness of these Principles
  6. To report on activities and progress towards implementing these Principles.

If you're interested in finding out more information regarding how hedge fund managers can utilise ESG funds, take a look at our exclusive eco-conscious investors report - highlighting which industries have the most opportunity for sustainable investments and best performing sectors.

Publication date: 2022-04-13T13:51:42+0100

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