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Hedge Funds in the SRI context – steps taken and the potential leaps ahead

Increasing numbers of hedge funds are seeing opportunity in the responsible investment space.

The increasing embracement of SRI and ESG criteria is rapidly changing the mainstream investment industry. Traditional banks and fund managers are responding to their client’s SRI awareness by creating solutions that seek to cater to this surging demand. Many are unaware that this is also affecting hedge funds in meaningful ways. Since hedge funds tend to be active investors and employ adaptive investment strategies to the prevailing market conditions, they have excellent prerequisites to embrace SRI/ESG factors as part of their investment strategy. “You better start swimming or you’ll sink like a stone!” The mid-1960s proclamation of Bob Dylan rings very true today, with capital markets having recently been shaken to their core. Hedge funds were not spared. Despite some having fared substantially better than traditional investments, hedge funds on average did not achieve their absolute return targets in 2008. However, as hedge funds are exposed to alternative risk premia that are not accessible through long-only vehicles, their risk/return characteristics will remain superior and exhibit low correlation to traditional investments. It is our conviction that hedge funds will continue to have aplace in diversified institutional investment portfolios, just as we are equally convinced that SRI is gradually becoming an integral part of the financial industry. As institutional investors increasingly incorporate SRI, these investors will require the ability to express these requirements across all their investments, including hedge funds. Many large institutional investors struggle with the need to maintain portfolio diversification whilst implementing SRI across the whole portfolio. In short, there is a pronounced and growing demand for hedge funds that offer products managed in accordance with SRI principles; and still a limited supply. This is changing, and at Harcourt we are proud to play an active role in this development in our quest to get hedge funds to increasingly embrace SRI. As the hedge fund industry manages assets in access of US$1.4 trillion (HFR, December, 2008), they can play an important role in emphasizing the importance of ESG/SRI in the capital markets. The growing interest in sustainability investment, we believe, has, amongst other things, been driven by the apparent challenges the world is facing. With estimates that the world’s population will grow to

9bn by 2050, the dramatic redrawing of the demographic landscape will occur in conjunction with increased globalization and resource consumption at a rate far surpassing long-term capacity. This exploration of resources (be it human, natural, or economic) will not only have far reaching consequences on our environment and society, but also on the capital markets. These challenges are undeniable and something we all can relate to, hedge fund managers being no exception. How these challenges are drastically changing corporate and investor behaviour in terms of both risk and opportunity are the two main drivers why hedge funds are increasingly starting to incorporate ESG/SRI information into their investment strategies. There are two main approaches by which hedge funds can do this. Either the hedge fund can adjust its “standard” investment strategy by limiting its exposure to a (predefined) list of approved SRI compliant instruments. Alternatively, the hedge fund can use ESG/SRI criteria as input into taking long and short positions in instruments based on how well ESG/SRI is reflected, or will be reflected, in the value of such instruments. In the first approach, the hedge fund (preferably with the SRI investor) will need to assess whether the approved list of instruments enables the manager to utilize the same type of investment strategy and investment philosophy in the constrained list. 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. As with a long-only mutual fund manager, the critical aspect for the SRI investor is to assess the manager skill of the hedge fund within this constrained universe. One major benefit for the SRI investor is that the hedge fund doesn’t change its investment approachbut merely adjusts it to instruments deemed SRI compliant. This makes it easier for the hedge fund to embrace ESG/SRI criteria based on the existing investment process for which it has a track record. The second approach requires the hedge fund manager to fully integrate ESG/SRI criteria into their investment approach by using ESG/SRI input in evaluating instruments and as a catalyst for going “long” good companies and short “bad” companies. This approach is likely to become more commonplace in the future as ESG issues are increasingly reflected in how the financial markets evaluate instruments. The latter approach is, however, likely to be more volatile than the constrained universe approach as ESG is not the sole catalyst for valuation changes of instruments. It is important to note that going short has a limited profit potential, whereas the risk of loss is unlimited. Shorting is therefore difficult to put into practice and requires a proven skill-set by the hedge fund. Further, given the complexity to short, it is likely that the hedge fund also on occasion will lose money by being short bad companies. This risk/return effect is obviously a key issue for the SRI investor to be aware of and to assess accordingly. In our experience it is possible to successfully incorporate ESG/SRI criteria in virtually any type of hedge fund strategy. As hedge funds are flexible and active investors they are suitable to explore the ESG/SRI trends prevalent in the markets. In light of these trends, we have for instance seen a large number of environmentally focused hedge funds focusing on wind energy, renewable energy, water etc. These thematic hedge funds have been around for a few years. The key issue for hedge fund managers when it comes to ESG/SRI is, of course, whether it is viable to incorporate it into their existing investment strategy

without putting limitations on the risk and return objectives. In other words, all else being equal, it has to perform as well as non-ESG/SRI. One common critique is that any limitation to the investible universe will hamper the possibility for return generation. This issue has been subjected to many academic studies and mostly they come to the conclusion that it is rather manager skill and investment style that ultimately determines the performance effects of incorporating SRI. 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 that create vehicles that incorporate SRI will prevail. Indeed, even 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/ESG compliant context without hurting performance.
The positive developments within the SRI industry are leading to an increasing diversity of SRI-related investment opportunities in various asset classes. The UK Social Investment Forum (UKSIF) recently published a discussion paper on “Sustainable Alternatives” and looked at SRI related solutions that exist within hedge funds and alternative asset classes.
The report confirms a broad diversity and predicts thatthe number of such investment solutions is set to rapidly increase. This means that institutional investors will increasingly be able to create truly diversified investment solutions, using all asset classes, which are in compliance with SRI criteria. All these trends paint a very positive picture, but a word of caution seems appropriate. As for any new market trend, new players enter constantly. Some of those are valid and have truly institutional-quality processes and products. Many of them do not. As such, it is difficult to separate the high quality players from less serious ones. SRI investors are therefore encouraged to get thoroughly educated and conduct rigorous due diligence on each offering related to SRI hedge fund investing. One of the key challenges for the SRI industry has been the lack of a uniform definition. However, as the awareness and true understanding of SRI increases, we see signs of harmonization of SRI approaches and policies. This process is largely facilitated with initiatives such as UN PRI, even though there is still a long way to go before a standardized framework is defined. We believe this is the single most important issue for the SRI industry to focus on going forward. At Harcourt, we are proud to be a signatory UN PRI and we strongly support that initiative as it forms a critical aspect in getting more hedge funds to incorporate SRI.
Erik Eidolf is executive director at Harcourt Investment Consulting