Is it possible for a hedge fund to adhere to SRI principles?
Hedge funds are adopting policies supporting socially responsible investing. It is possible for them to adhere to such principles, helping them attract capital from a new set of investors
It is absolutely possible for hedge funds to adhere to socially responsible investing (SRI) principles. Many managers take SRI considerations into account already but without an explicit reference to SRI principles.
SRI principles can be flexible and include governance. Many hedge funds adopt governance best practices, for example those promulgated by the Hedge Fund Standards Board.
Investors, however, are also concerned with demonstrating that the managers they select comply with the investor’s own SRI policies in regards to social and environmental issues.
Hedge funds encounter a number of issues around definitions that confuse the application of SRI principles to the way they invest. They are not strategies per se and are better described as legal structures that come in various forms and are able to invest in diverse assets.
The strategies used by hedge fund managers may differ widely. Any single hedge fund may use a combination of strategies, which may vary over time as market opportunities ebb and flow. While at first it may be hard to see how to apply SRI principles to this dynamic reality set, looking beyond the definitional issues we see that how SRI principles apply to other asset classes within an investors’ portfolio can be directly applied to the different strategy components within a hedge fund.
This can be evidenced through a hedge fund manager having SRI policies in place that are specific to a range of strategy components and then reporting against the policy for each of them to show the investor that they are in compliance.
Matthew Fitzmaurice, AWJ Capital Partners
Hedged managers can maintain their singular focus on generating absolute, risk-adjusted returns and adhere to socially responsible investing principles.
We believe we are in the first inning of a multi-decade opportunity to invest long in those public market companies that are solving issues related to the burdens placed on water, agriculture and energy born of population growth, an exploding global middle class, urbanisation and the movement toward higher-protein diets.
Simultaneously these hedged managers can short those companies that ignore these trends and allow their business to deteriorate as they are held hostage to the vagaries of the availability of water, agriculture and energy and/or massive price fluctuations these resources have experienced over the past three to five years.
The result of investing long the ‘solutions’ providing companies is twofold: earnings growth of these companies accelerates and thus the share price increases; concurrently the invested capital allows the ‘solutions’ companies to grow. Ultimately, the hedge fund has provided capital to solve burdened resource issues.
Short investments accomplish two results as well. First, short sales of those companies that ignore the issues of burdened resources call attention to their reckless corporate behaviour. Second, these companies are starved of the capital to continue their business as usual corporate strategy.
Investing with an eye toward sustainability related to corporate inputs (water, agriculture, and energy) is really about profiting from opportunity and avoiding risk. The result is superior risk-adjusted returns. A byproduct of this investment style is a more sustainable world.
Jessica Matthews, Cambridge Associates
Not only is it possible for a hedge fund to adhere to SRI principles, it also presents an opportunity for a hedge fund to attract capital from a new set of investors.
A few years ago Cambridge Associates began witnessing increased demand from its clients for a solution to the problem: how can we diversify into hedge funds and do so in a socially responsible manner? While many of these sophisticated institutional investors have invested in hedge funds, they have historically been unable to do so in a manner consistent with their mission or values while others have simply avoided hedge funds altogether.
The disconnect merits some thought and action, as the number of institutional investors engaged in SRI investing continues to grow.
In response to this demand, Cambridge Associates began working with hedge funds to create separate SRI share classes. As part of the process the managers, with the help of a third party, audit their portfolios against a list of restricted securities. The audit is necessary both for the institution and the manager to determine whether a screened class is reasonable from a portfolio management perspective and does not materially deviate from the performance of the main fund.
Many hedge funds have been receptive to these efforts. Creating an SRI share class opens the doors for new capital from investors that otherwise would not invest in hedge funds, so there is a mutual benefit between an investor and hedge fund willing to implement these screens. There is now a diversified array of institutional-quality hedge funds implementing SRI screens that we can recommend to our clients.
Paul Jeffries, Permal Asset Management
The short answer is yes. The flexibility of most hedge fund managers’ mandates means that they can dictate their investment parameters which may also mean incorporating environmental, social and corporate governance (ESG) criteria in their investment decision making process. It is not only dependent on the wants of a manager but also their type of investment strategy, with some better suited to incorporating ESG than others.
There will of course always be those that will never consider such factors. But from where I sit, I think it goes hand-in-hand with the development and growth of the hedge fund sector as it has matured.
Times have changed and today some of the best-known hedge fund managers are among the world’s biggest philanthropists. There is far greater awareness of social responsibilities, which is being translated into portfolio decisions. A decade or so ago, very few hedge funds would have signed up to responsible investment initiatives such as the United Nations supported Principles for Responsible Investment (PRI) but the world was very different then.
There has been a change in mindset and a change in the way funds are managed. It is no coincidence that this increased interest is also aligned with developing investor priorities, particularly those of institutional investors, who are becoming the main investors in hedge funds.
As a hedge fund investor, Permal is a UN PRI signatory and we incorporate ESG issues in our fund analysis and require appropriate disclosures from funds that we invest in, which are then used in our ex ante assessment of risk and return. Looking ahead I think it is likely there will be further developments, with the UN PRI principles becoming increasingly de rigueur among hedge funds.
Hedge funds are not the obvious candidates for adopting responsible investment principles but it is not an impossible idea.
Aled Jones, Mercer
At Mercer we define responsible investing (RI) as the integration of environmental, social and corporate governance issues into investment management processes. We believe these factors can be material and should be assessed and managed by fiduciaries appropriately.
RI practices are most common in asset classes providing equity, and therefore ownership rights, to investors, such as listed equities, property, private equity and infrastructure. The short-term quantitative nature of many hedge fund strategies means that ESG issues are rarely relevant. However, if considering ESG issues gives a broader understanding of the risks of a particular security then some strategies may benefit (for example, equity long/short or distressed debt).
Mercer’s own research indicates that a minority of hedge funds are integrating ESG issues into their strategies already. Our assessments of ESG integration by managers finds that only 9% of more than 5,000 strategies across asset classes achieve our highest rating (ESG1 or ESG2, the lowest is ESG4).
When hedge funds are isolated that figure falls to around 2%.
So where does that leave us? Hedge funds are limited in how they can integrate ESG into individual investment strategies. However, all funds could and arguably should consider improvements in one area – governance and transparency. Efforts are underway. Industry-led initiatives such as the Hedge Fund Standards Board and Alternative Investment Management Association (Aima) both promote better governance standards. Also, the emergence of the UN PRI in 2006 has increased the attention paid to RI issues across all asset classes. Indeed, last year it released a paper, “Responsible investment and hedge funds”. Watch this space.
Larry Abele, Auriel Capital
While we agree with Ralph Waldo Emerson that “a man is usually more careful of his money than he is of his principles”, we are committed to both as money managers who take the UN Principles of Responsible Investing seriously.
We have worked hard over the last few years to integrate environmental, social and governance research into our investment process in a way that improves risk-adjusted returns. In our process companies receive negative scores if we find them lagging their peers on ESG dimensions we deem material in their sector.
Our approach is not ethical per se but more practical in that we want to evaluate the environmental and social externalities being created by companies in order to better understand their risks and value proposition. This research led to one of the more difficult ethical dilemmas I have faced since becoming a hedge fund manager.
In early summer 2012 we opened a short position in Lonmin due in part to labour union concerns in their South African platinum mines. Then on August 16, 34 striking mineworkers were killed by police with accounts varying widely by news agency. The stock fell just over 15%, which was about $400 million worth of market capitalisation wiped out. Of course we had an overwhelmingly sad feeling about the human tragedy but we also had made profit on this tragic event.
We sat in our office with our concerns validated but wondering if $400 million was an overreaction. In the end we decided the stock had fallen too much (despite our moral outrage to this abominable event) and we closed our position.
Ultimately, ethics is an important part of our investment process and we traded Lonmin exactly as our process is designed. This case was unique, however, in that so many lives were involved.