How should we approach ESG in the hedge fund space?

By Sanan Pillay, Head of Alternatives Research, Sanlam Investments Multi-Managed business (Investment partner of Graviton)

Environmental, social and governance (ESG) considerations have been a prominent and rising theme in investing in the global investment industry and is gradually becoming something that investors will expect, rather than something that is optional. As ESG considerations become more entrenched, attention has turned to the matter of how the hedge fund industry will be incorporating ESG into their operations.

ESG becoming an expectation

Historically, the hedge fund industry has benefitted from comparatively less scrutiny and greater flexibility in what they could invest in. They have thus been somewhat shielded from the broader ESG trend that has been impacting the traditional asset management industry. However, as investors become accustomed to seeing ESG considerations factored into their long-only portfolios, they started asking questions around what hedge fund managers are doing with respect to ESG.

A wide variety of hedge fund approaches

There are wide varieties of hedge fund approaches out there, and the idiosyncrasies of the hedge fund industry create numerous issues when considering how to incorporate ESG into hedge funds. For example, a hedge fund which analyses the macroeconomic environment and expresses its views using futures would not have any obvious avenue to incorporate ESG actions into their portfolio management. Similarly, managers who engage in short-term trading and do not hold securities for long periods may also lack the ability to effect any improvements in the ESG standing of those businesses.

Hedge fund managers that typically have scope for ESG initiatives in their operations are those who invest directly in securities (i.e. not derivatives of securities) and have holding periods for their underlying investments that are somewhat similar to traditional long-only asset managers, because they typically have the time and opportunity to engage with company management.

Managers with ESG initiatives that are typically more difficult, or those who hold their securities for shorter periods, invest in derivatives. Derivatives do not come with any rights with respect to attendance of shareholder meetings or voting on company decisions, and short holding periods for securities could also preclude managers from engaging management on ESG considerations due to the practical time considerations.

This raises the question of whether it is fair to have the same ESG expectations for hedge fund managers across the board, or whether a more contextual approach should be employed. While it is important to not give any fund managers special treatment, it is also important not to penalise managers for something that is genuinely outside the scope of their operations

Towards a solution

One solution to this problem would be to separate those types of hedge funds for which ESG initiatives may currently be out of scope, and to assess their ESG initiatives, taking this into account. This would not necessarily have to be a permanent separation, but it would give the industry and fund managers more time to build the databases, systems and necessary processes to make ESG-related actions and engagements more feasible for a broader range of hedge fund managers.

The difficulty of implementing ESG actions within a hedge fund strategy also raises the question of whether ESG should be viewed at a broader level than just the fund being evaluated. While some fund managers may be limited in their ability to influence companies and governments to consider ESG factors, they may still possess the ability to positively influence the world through their own private initiatives such as bursary programmes and the sponsorship of other initiatives with a positive social impact. Expanding ESG evaluations to work at a firm level rather than just a fund level would thus increase the opportunities for the industry to have a positive impact on the world, and may also be a more fair way to encourage all hedge fund managers to make an effort towards considering their broader environment and whether they are having a positive impact on it.

Our approach

Within the Alternatives Research team, we seek to regularly engage with our hedge fund managers on what they are currently doing with respect to ESG, as well as what they are doing to improve. Through our relationships with our managers, our industry knowledge and through honest engagements, we consistently seek to improve our hedge fund managers’ considerations of ESG factors within their strategies and general operations.

While the urgency of the environmental, social and governance issues facing our world necessitates immediate action, it is also necessary to recognise that the path to mobilising the ability of the hedge fund industry to positively influence the world is a long and complex one. We have only just begun the process and look forward to the opportunities that lie ahead.