This section provides an overview of responsible investment and its application to the hedge fund industry. It also outlines three key drivers (regulation, materiality and client demand) and the relevance to hedge fund managers and those allocating to these strategies. From an asset owner perspective this section also provides an overview of PRI’s RI due diligence questionnaire. This has been developed for asset owners allocating capital to hedge fund managers.
Figure 1: Approaches to PRI Principle 1 (incorporation) and Principle 2 (active ownership)2
Hedge funds represent a heterogenous group of managers with a wide range of investment strategies, different governance structures and an ability to invest in a range of assets and financial instruments. Aspects of the approach to ESG incorporation (Principle 1), active ownership (Principle 2) and communication or reporting (Principle 6) differ from long-only security and private equity investors.
What is responsible investment?
The PRI defines responsible investment as a strategy and practice to incorporate environmental, social and governance (ESG) factors in investment decisions and active ownership. There are many approaches to responsible investment but these are typically a combination of two areas.
This report can be used as a point of reference for hedge fund managers to review and develop their own approach to responsible investment according to their investment strategy. 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.
Key drivers for hedge funds to considering responsible investment fall into three groups.
Figure 2: Key drivers
Figure 3: Number of signatories with internally managed hedge fund strategies (2019)
The interest in RI among signatories allocating to hedge fund strategies is encouraging asset owners to increasingly question hedge fund managers about their approach to RI. To facilitate this process, the PRI has published a Due Diligence Questionnaire for Hedge Funds for asset owners. This is the first industry-standard tool for investors to assess hedge fund managers on their responsible investment policies and practices.
Client demand and DDQ
Recent estimates suggest that hedge fund industry assets will reach new all-time highs in 20203, continuing a pattern of almost continuous growth over the last decade.
In line with this, and more broadly with PRI’s increasing signatory base, the number of signatories reporting on the hedge fund module in PRI Reporting and Assessment has also 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.
Figure 4: Number of signatories allocating to externally managed hedge fund strategies (2019)
The DDQ for hedge funds helps asset owners identify those hedge funds that have the personnel, knowledge, and structure to incorporate environmental, social and governance (ESG) factors in the investment decision-making process and was developed alongside industry bodies.
Figure 5: Purpose of the hedge funds DDQ
|GUIDANCE||A standard for use by investors considering responsible investment as part of their due diligence process for a hedge fund investment.|
|DIALOGUE||Facilitate a two-way dialogue between investors and investment managers on responsible investment.|
|DATA||Standardised questions reduce reporting burden and facilitate comparison between peers, crosschecking of information and data consistency.|
|ACCESS||The same questionnaire is available across different industry platforms – the PRI, the Alternative Investment Management Association (AIMA) and Standards Board for Alternative Investments (SBAI), eVestment and DiligenceVault.|
Figure 6: Hedge fund DDQ development process
In Figure 7, we review some of the growing body of academic and industry evidence supporting the premise that identifying and incorporating ESG factors into an investment process may contribute to relative outperformance in certain asset classes. The PRI has also collated a register of academic research which covers a range of topics including reviewing the materiality of ESG factors in asset selection.
Like many other investment approaches, certain hedge fund strategies have primarily focused on governance issues in ESG. For instance, activism and engagement with senior management of companies have been important drivers of returns in event driven and activist hedge funds as well as equity long short funds.
Figure 7: Assessing materiality and correlation with returns
Assess materiality of ESG factors
Correlations between ESG and returns
There is a long history of industry and academic research into this topic. In 2003, Paul Gompers’ work on the correlation between shareholder rights and profitability, sales growth & M&A was a seminal piece that lead the way. More recently, this type of work has been extended across a range of asset classes that are relevant to hedge fund managers.
Correlation not causation
Most academic and industry work focuses on identifying correlations between ESG factors or rankings and returns or corporate financial performance. Few try to establish or explain causation between better ESG performance and improved corporate financial performance, absolute or relative portfolio or benchmark returns. Sometimes these are aggregated measures of governance, environmental and social performance, sometimes they reflect only a single aspect. They can help investors make more informed decisions but do not capture the implications of factors or trends on corporate or issuer balance sheets, profit and loss accounts or cash flows. Some organisations have tried to explain correlations by outlining three transmission mechanisms: cash flow channel, idiosyncratic risk channel and valuation channel.
Correlations – changes over geography, time & sector
Various research papers identify correlations between ESG scores and financial metrics such as quality, price to book, profitability, volatility, returns and market cap. These relationships often vary in strength depending on the time period and region. One notable and repeatable correlation seems to be between ESG rankings and emerging market equity returns. Many reports split environmental, social and governance rankings – again showing different correlations with most (but not all) surveys identifying governance as the metric with the strongest and most consistent correlation with returns – across a range of asset classes.
The strength of correlations also varied over time, with some commentators highlighting that the correlation strengthened during periods of raised market volatility or market disruption.
Alongside geography and time, correlations between corporate financial performance and ESG rankings also varied between industrial sectors, with a closer correlation in sectors with a greater reliance on heavily regulated activities or those which required a ‘social’ licence to operate. For example, within sectors such as resources, consumer and utilities there is seemingly a stronger statistical relationship between ESG and corporate financial performance.
Correlations – absolute versus rate of change
Another feature of academic research was the delta positive or negative change or rate of change in ESG scores (rather than just the absolute or relative value), which provided an interesting signal in terms of asset returns.
For further information and sources, please have a look at our online PRI resources:
Guidance and policy intervention relating to stewardship, disclosure and RI has increased significantly since the 2008 global financial crisis. Changes have been driven by a range of factors including a realisation among national and international regulators that the financial sector can play an important role in meeting global challenges such as climate change, modern slavery and tax avoidance.
Figure 8: Regulatory categories
|ASSET OWNERS||STEWARDSHIP||CORPORATE DISCLOSURE|
|Asset owner regulations are usually focussed on disclosure requirements for pensions funds (e.g. as part of a statement of investment principles) or key state-owned asset owners. Prudential regulators are beginning to consider climate risk in the insurance market..||Stewardship codes govern the interactions between investors and investee companies, to encourage better governance, and protect shareholders||Guidelines, typically from government or stock exchanges, encourage or require companies to disclose the information on ESG risks and opportunities that investors need. Disclosure can also raise awareness of ESG issues within a company, which can lead to them being managed better.|
As the client base for hedge funds is qualified or accredited investors, the regulator oversight is different from mutual funds, pension funds, and other investment vehicles. However, ‘soft’ law, codes of best practice, fiduciary duty and changing regulation affecting clients are still highly relevant.
The implications of increasing interest in RI are similar for all investment managers but for hedge funds there are three particularly relevant benefits:
- As hedge funds can invest in a broad range of assets, these strategies can benefit from ESG themes such as climate change, resource scarcity, energy transition and SDGs in innovative and different ways;
- Renewed focus on different aspects of governance and compliance may contribute to strengthening governance structure and reducing principal-agent issues;
- RI policy development and implementation can contribute to improved industry disclosure, transparency and accountability.
The PRI regulatory map provides signatories with an overview of current and developing regulation. It groups regulation into: ESG regulation targeting asset owners, stewardship codes and corporate disclosure guidelines. The map lists the year, responsible authority and voluntary / mandatory nature.
3 Don Steinbrugge (9/1/2020); Hedge Fund Week Top hedge fund industry trends for 2020