Hedging in a time of crisis

Hedge funds have traditionally been sceptical about their ability to embrace responsible investment practices. However, since the 2008 financial crisis, when hedge funds played an important role as providers of liquidity, with strategies focused on private or distressed debt or event-driven and special situations, helping to restructure and rescue companies, the importance of investing sustainably is now more firmly on their radar, with many strengthening their governance structures in the face of increased scrutiny from regulators.

The hedge fund industry is also at the forefront of data sourcing, using new sources of alternative unstructured data derived from artificial intelligence, in a bid to generate new insights before competitors. This applies across all data sourcing, using ESG-specific data as well as data in more standard areas.

A report published in February of this year by the Alternative Investment Management Association (AIMA), CAIA, CREATE-Research and KPMG has found that 59% of hedge fund managers are either at the ‘mature’ or ‘in progress’ stage of implementing ESG via appropriate policies, committees, research and data. Certainly at the PRI, over the last four years, we have seen a steady increase of interest from hedge fund managers either to join the PRI or to know more about our work. Interestingly, the number of signatories reporting on the hedge fund module in the PRI Reporting and Assessment framework has increased over the last two years. PRI signatories began reporting on the Hedge Funds Module in 2018 and the latest data (2019) shows that approximately 8% of PRI signatories have internally managed hedge fund strategies. Approximately 12% of PRI signatories have an allocation to externally managed hedge fund strategies.

When the PRI published the RI DDQ for hedge funds in 2017, most hedge funds were unsure about what it meant for a hedge fund manager to be a responsible investor. This guide set the baselines and urged hedge fund managers to adapt it to their own investment approach. By their nature, each hedge fund strategy is unique so a “one size fits all” strategy will not work and, due to the sheer breadth and range of trading instruments and market strategies spanning equities, fixed income, commodities and FX, some hedge funds are likely to be better placed to integrate an RI policy than others. However, there are some components that all hedge funds can include in their approach to ESG integration; namely, policy, governance, investment process, and monitoring and reporting.

Hedge fund managers cannot ignore the growing trend that ESG criteria is playing an increasingly significant role in the manager selection process of institutional investors – represented by the steady growth of the PRI’s asset owner signatory base (from $20.1trn in 2019 to $23.5trn in 2020). ESG due diligence is becoming the norm, and a manager’s responsible investment practices form part of the criteria that asset owners use when selecting managers. We are seeing institutional investors becoming increasingly interested in how hedge fund managers are applying ESG factors in their portfolios and have seen some hedge fund managers losing mandates because ESG is not embedded in their portfolio.

The PRI will continue raising awareness on RI practices across the hedge fund industry. The hedge fund guide that we have produced serve as a baseline for what a hedge fund manager needs to be aware of when developing and implementing an RI programme. The time has come for the hedge fund industry to think about responsible investment beyond new products, increasing AUM or identifying new investment opportunities and risks. Market participants must now widen their perspective to consider their role and responsibility as stewards of assets.

Six things that hedge fund managers can do to ensure capital is reallocated to more sustainable business models

Engagement and stewardship: Hedge fund managers are among the most active money managers in the finance sector. They can make sure the businesses they invest in are fit for purpose while including ESG conditions to drive operational improvements – from the supply chain to the end customer – to ensure these investments don’t represent a cost for society and the environment.

Transparency: Linked to this engagement, hedge fund managers can and should push for better disclosure and accountability in the responsible investment practices of the companies and issuers they invest in.

Shorting: The motivations behind shorting can vary, and the practice is seen as contentious by some, but if it’s done with the right spirit it can trigger major changes – and in a crisis recovery, change is much needed to ensure there will be no return to the situation(s) which caused damage in the first place.

Innovation and data: Technology and human capital represent competitive advantages for many hedge funds, especially as most of the data they deal with on a daily basis is unstructured, requiring interpretation from people and systems to find beta or alpha. A period of recovery should provide hedge funds with a further incentive to apply an ESG lens to their innovation and expertise.

Client demand: According to recent industry research, 34% of institutional investors believe ESG issues are material to investments, while another 44% think ESG-oriented investments provide opportunities for alpha. To be clear, this means there is significant client demand for hedge funds to take ESG factors into account within their strategies, and to develop new sustainable products.

Leadership: Hedge funds can stand out in this time of crisis to really showcase their skills while also driving change to rebuild the economy.

Marisol Hernandez, Head of Asset Owners at the Principles for Responsible Investment, leading the work for asset owners, developing programmes for selection, appointment and monitoring of external managers, and passive investments.