ESG strategies lengthen hedge fund holding periods

Hedge funds are not famed for being do-gooders. Yet as the spread of responsible investing across the wider asset management industry gathers pace, they are spotting ways to use these strategies to turn a profit.

The Alternative Investment Management Association, the industry’s lobby group, says hedge funds are using environmental, social and governance principles for a growing proportion of their assets.

In May it published a survey of 80 firms globally, which found that just over a tenth, or $59bn, of their combined $550bn under management have been committed to such strategies so far.

Though Aima concedes that the survey may be “positively biased” towards firms that already have an interest in responsible investment, the findings are a sign that hedge funds, best known for short selling (betting on the fall in the price of an asset) and other forms of speculation, are considering the longer game.

Fund managers point to a range of drivers behind the shift, most notably client demand, regulation and risk management. Another emerging factor is the potential for outsized returns.

Per Lekander, partner at Lansdowne Partners, one of the largest hedge funds in London, says that although these investors are late to the party they are here to stay. “There is more focus on companies bringing something good to society,” says the fund manager, who previously worked at Norway’s sovereign wealth fund, an influential proponent of sustainable investment.

Having a green-friendly culture internally is also good for recruitment, he adds. “These issues are clearly of importance for millennials.”

However, hedge funds’ traditionally shorter-term investment holding periods conflict with the longer-term nature of sustainable investing, Mr Lekander says, and many clients do not want to be exposed to the added volatility that this can entail.

Jason Mitchell, co-head of responsible investing at Man Group, the world’s largest listed hedge fund firm, says some of this conflict can be minimised through a better appreciation of the potential risk management benefits.

“The case for responsible investment needs to be better framed to hedge funds, from the importance of exclusions-oriented strategies, to how systemically embedding ESG into the investment process can improve an understanding of risks,” he says.

Nicolas Jamet, senior quantitative analyst at RAM Active Investments, says that while it is difficult to quantify the extent, increased adoption of ESG among hedge funds is starting to have an impact on investment timeframes.

“The inclusion of such factors is adding stability in our stock selection which then tends to increase the average holding period,” he says.

ESG adds stability in our stock selection, which then tends to increase the average holding period

Mr Jamet says RAM has been applying ESG principles to identify operational efficiencies and those companies likely to outperform their peers over the long term. This he says, “adds value in the way we understand a company” and improves performance.

Hedge funds’ embrace of ESG is also an attempt to get ahead of the regulatory curve.

The European Commission, for instance, published proposals in May that aim to incentivise private finance to put its “full weight” behind climate commitments.

This includes a regulatory framework and disclosure obligations for institutional investors. Such changes are prompting Man Group to embed ESG principles across the manager’s strategies, Mr Mitchell says.

One hedge fund analyst, who declined to be named, says regardless of whether the regulation directly affects hedge funds, “there is going to be increased pressure from investors for managers to provide some level of reporting”.

Appetite for ESG among hedge funds in the US is perhaps less clear.

In 2015, the US Department of Labor gave tentative support to pension funds’ adoption of ESG as long as it did not hurt returns. However, in April this year, it said pension fiduciaries “must not too readily treat ESG factors as economically relevant”.

David Silverman, managing director at Blue Harbour Group, a US activist firm, says the European market is more advanced than the US on responsible investing. “Overall, European companies have superior disclosure of ESG factors in comparison to US peers,” he says.

Companies that look bad from an ESG perspective but good in terms of turnround potential are generally less likely to qualify for many funds, therefore limiting managers’ ability to capitalise on inefficiencies.

However ValueAct, a San Francisco-based investment company, recently launched its Spring fund. This takes positions in companies that might not fit ESG criteria now, says Allison Bennington, partner at the firm, but which could be “highly successful in the long term” if they were to adjust their business models.

With client demand for sustainable products rising 50 per cent in the past year alone, according to Aima, the sector is starting to recognise the powerful incentives to include ESG in its portfolios.