How the hedge fund industry can help spur the responsible investment movement

Every sector of the asset management industry has a role to play

Hedge fund firms have always embraced change and responded to investor demand. Responsible investment is no exception to this rule. Arguably, one of the biggest trends reshaping the global asset management industry today is having firms look to do well, while also doing good.

Every sector of the global asset management industry has a role to play in this transformation, and no role may be more important than that of the hedge fund industry. While the hedge fund industry is still relatively new to responsible investment, hedge funds, with their technical expertise and knack for innovation, can play a major role in overcoming some of the barriers faced by the responsible investment movement.

In a recent joint research study conducted by the Alternative Investment Management Association (AIMA) and the Cayman Alternative Investment Summit (CAIS), we found that, globally, hedge funds have at least $59 billion in assets under management specifically allocated towards responsible investments. This figure is likely to grow. Half of all hedge fund firms surveyed reported an increase in investor interest in responsible investment over the last 12 months, and nearly a third reported that they either already have a responsible investment expert on staff, or are planning on hiring one over the coming year.

These trends are important, but asset flows and environmental, social and governance (ESG) experts are not the only way the hedge fund industry will contribute to the responsible investment trend. Hedge funds, with their unique traits and active approach to investing, can make a number of contributions to help catalyze the responsible investment industry. Here are three of them.
Activist investing

Unlike passive, long-only asset managers, hedge fund firms are free to engage with the management teams of their portfolio companies, in order to drive positive change.

Multiple academic studies have shown that activist engagements on ESG issues can lead to measurable outperformance in the months and years following an engagement, with little to no negative impact on performance for failed engagements. It stands to reason that more activist engagements can potentially lead to improved financial, environmental, and social performance for the companies in which hedge funds invest.

Several prominent hedge funds have a long track record of activist investing, and this expertise can be used to help effect change at companies in partnership with other shareholders. Last January, Jana Partners partnered with CalSTRS in an activist campaign to pressure Apple to do more research into how smartphone use and addiction impacts young children.

These types of campaigns tend to be very resource-intensive, making them a natural fit for hedge fund firms that specialise in effecting change in portfolio companies.
Technological sophistication

One of the major difficulties in evaluating ESG factors for a potential investment is the relative scarcity of reliable data. Many companies simply do not report on ESG factors or do so only in a cursory manner.

This complements what our study showed as the two most common challenges for hedge fund firms that are not yet engaged in responsible investment: (1) “inadequate methodologies for the calculation of sustainability risks” and (2) the “lack of relevant disclosures from companies”.Without companies publicly disclosing quality data that shows their performance on ESG issues, many managers will be hard-pressed to find a way to fully adopt these investment practices. Technology presents a potential solution.

Fortunately, hedge funds are world leaders in applying technology to asset management. Many of the world’s leading computer scientists and programmers are employed by the hedge fund industry, and hedge funds are pioneering new ways of monitoring and evaluating potential and actual investments.

“A hedge fund and a bank could structure a credit-default swap, triggered if a company fails to meet ESG criteria.”

This level of technological sophistication is crucial to the responsible investment industry because it allows for the rigorous tracking and measurement of each company’s performance on ESG factors. For instance, a hedge fund may be able to use satellite imagery to monitor the pollution caused by a factory, and then incorporate that data into a proprietary ESG scoring system. This ‘big data’ approach is uniquely well-suited to hedge funds, many of which are already employing powerful statistical and computational data to sift through mountains of information and determine what is or isn’t a material ESG risk or opportunity.

Innovative financial instruments

The hedge fund industry has contributed to many of the financial innovations that the financial markets now rely upon, from algorithmic trading to securitized debt. This willingness to experiment is crucial to the success of the responsible investment movement, which is currently limited to a relatively narrow range of investment products when compared to the rest of the asset management industry. We are just now starting to see product development move into more niche areas, highlighted by the recent launch of ESG-specific target-date funds and money market funds.

Hedge funds can play a role in pushing this development further by creating customised financial instruments to allow for easier entry (and exit) into the responsible investment market, ultimately helping to build a robust secondary marketplace that provides liquidity options for responsible investors looking to exit or reallocate their positions.

In particular, a more sophisticated derivatives market would allow asset owners such as pension funds and sovereign wealth funds to better hedge their risk and to efficiently trade in both public and private markets. As one example, a hedge fund firm could work with a bank to structure a credit-default swap that can be triggered if a company fails to meet specific ESG criteria. These types of derivatives and other instruments could therefore open the door for a larger and wider range of asset managers and owners to join the responsible investment movement.

We are still in the early days of responsible investment, and the continued growth of this field in the future will likely depend on the removal of key structural barriers. The hedge fund industry, working in partnership with other industry players, will be key to its long-term success.

Jack Inglis is the CEO of the Alternative Investment Management Association (AIMA) and Tony Cowell is Partner, Head of Asset Management at KPMG in the Cayman Islands.