May 2019

Environmental, Social & Corporate Governance, ESG Investing, Hedge Fund Investors

Society is on the precipice of major shifts in wealth, energy sources and morality, could ESG investing turn the heads of hedge fund managers?

Description: Will ESG investments be a part of Hedge Fund portfolios?

ESG investing represents the factors that measure the sustainability and ethical impact of an investment in a company.



ESG investing may only recently be building momentum, but its roots stretch back to the 1800’s where Quaker and Methodist societies created their own guidelines for socially responsible investing.



Companies with strong ESG profiles could be better positioned to deal with future challenges since they have fewer cases of bribery, corruption, fraud and other debilitating acts that have an impact on social responsibility.





The changing landscape

The investor of tomorrow is not what most Hedge Funds are familiar with. Due to changes in equality, wealth and morality we are seeing younger investors, a higher number of female investors and investors concerned with the impact of their decisions on the environment, sustainability and even animal cruelty.

As Millennials and Gen X take the reins from the Baby Boomers, we are seeing a similar evolution on a global scale.

Half of the members of the new French Government are women, Germany will complete an entire shutdown of nuclear power by 2022 and alternative energy sources gain momentum worldwide on a yearly basis.

With this change, many industry experts believe that ESG investing could be key to bridge-building for next gen clients. Even the larger Hedge Funds are acting, AQR Capital Management who have $226 billion AUM released a responsible investing framework in partnership with the United Nations principles for responsible investment.





The common misperceptions with ESG investing

Ask anyone interested in ESG investing to explain the term and you will likely get an answer that revolves around companies “doing the right thing”. This could be why many in the industry are labelling ESG as a “hippie trend” or a “flash in the pan”.

ESG investing has a logical and more practical use than simply saying “it is good for the environment therefore I will add it to my portfolio”.

There are a multitude of circumstances where environmental, social pressures or poor governance could result in disruption.

Example; The EU passes a law limiting crude oil imports due to climate change. One must evaluate whether they are hedged against the turbulence this will cause in the UK’s Brent Oil production.

ESG profiles can uncover details that would have otherwise been missed. Example; 3% of all power in California goes to cannabis production, with 1% of all power being used for the same process in the entire US. In an industry where many are jumping on the bandwagon, information such as this would have been overlooked.

It’s often forgotten that on the buy side, mitigating volatility in one’s portfolio by protecting against future scenarios (Bad press for sexist hiring policy/Low carbon targets will affect commodities market) is what ESG investing is used for.

Another common misperception is what makes a high scoring ESG company. Ask someone to come up with a high scoring ESG company and they may say Tesla for obvious reasons. Their entire concept revolves around being green and using alternative energy to replace the status quo.

So why are Tesla badly ranked for the social criteria being below the average in their industry? Additionally, why have Tesla achieved a score of 70/100 for environmental factors, when Ferrari have a score of 56/100? For a company that uses electricity to power its cars vs petrol it raises questions as to how the ESG rating system is carried out.

What’s included in the ESG rating system?

In order to understand the ESG profile of a company it helps to understand the rating scale they are being measured by.

Bloomberg have a rating scale out of a possible 100 for 120 factors that are re-evaluated on an annual basis. A selection of the Bloomberg criteria includes;

Carbon emissions

Climate change effect

Pollution

Waste disposal

Renewable energy

Resource depletion/resource scarcity

Supply chain

Political contributions

Discrimination

Diversity

Community relations

Human rights

Cumulative voting

Executive compensation

Shareholders rights

Takeover defence

Staggered boards

Independent directors



ESG on a larger scale

ESG ratings have also been applied to countries, with Finland being the most ESG compliant, followed by Netherlands and Denmark. Surprisingly South Africa ranks above the UK which raises questions as to how the ESG country ratings are conducted.

Europe is managing 48% of all the ESG managed assets, therefore it is certainly no shock that Europe holds the top 3 spots.



How do Hedge Funds view ESG investments?

According to a report from a respected Hedge Fund data platform, 65% of Hedge Fund investors say ESG investing will become more important in the next 5 years.

However only 37% of Hedge Fund managers said the same with just 20% of Hedge Fund firms surveyed having their own ESG policies in place. Additionally, 15% of the remaining Hedge Funds surveyed said they planned to put ESG policies in place by 2020.

Compare this to the Private Equity industry where 53% of firms already have ESG policies in place.

It’s likely that this difference of opinions reflects the pressure Hedge Fund Managers are under to not only perform, but to produce significant returns in the short term. In contrast ESG investments are currently viewed as longer term and naturally more constrictive, a trait Hedge Funds traditionally have not favoured.

Should Hedge Funds adopt a more dominant ESG policy, it would see an entire shift, not only in strategy but identity.

This does not mean Hedge Funds are stubbornly ignoring the impending changes. 40% of Hedge fund managers surveyed were practicing responsible investment and half reported increased investor interest in ESG which displays increasing awareness. Click here to learn more.

It must also be said that many Hedge Funds are involved in philanthropy. Man Group’s good deeds include; Fund raising, volunteering opportunities, promoting literacy and numeracy in the UK and providing grants.



Can ESG investments generate Alpha?

According to Conor Platt CEO at Confluence Capital and formerly of Etho Capital, ESG investing can reveal things that others are not looking at. Conor believes that a companies ESG profile is a major indicator to their predicted future especially on the short side.

Conor claims that if a company is inefficient by their standards, has bad financials, governance and stakeholders, then it can be particularly profitable on the short side as it is an unsustainable company and an excellent candidate in his opinion.



ESG factors that will become more prominent beyond 2019

Looking ahead it is difficult to deny that ESG investing will not continue to gain momentum and alter the way companies approach every decision.

Some of the factors that are sure to be prominent beyond 2019 include;



Climate change

As we gradually tip-toe toward the dreaded 2 degree increase in global temperatures, countries, companies and investors are becoming increasingly aware of their own influence on our planet’s future and the impact they will be having on their children’s future.



Investor and community trust

Step outside of the ESG standards and it may be hard to regain the trust of investors and more importantly the overall community, which consequently discourages investors furthermore.



Use of personal data and social presence

Facebook have developed a relationship with congress like that of an ex-convict who’s every move is either pre-judged or placed under a microscope. The misuse of user’s data has resulted in their platform losing millions of users and their efforts to create a crypto-currency being blocked by congress.



Access to medicine

Some investors have been supporting a right of access to medicine over the past few years. Many people worldwide do not have access to medicines that could be the difference between life or death. There has been increasing tension around the profit vs purpose debate. Pharmaceutical companies are caught in a limbo trying to satisfy investors who want to see profits and the opposing side who want to see increased medical results.



Social impact

An increasing number of investors are turning their eyes to impact assets that continue to focus on profits but are heavily influenced by how they make all parties involved appear socially.



Palm oil and deforestation

Due to its long shelf life palm oil is the most commonly used vegetable oil in the world even being used in chocolate. Palm oil carries controversy as it is produced in tropical rainforests leading to large scale biodiversity destruction in Asia. This has led to increased carbon emissions, soil erosion and loss of habit for various animals. Such issues are too negative for many investors to be associated with.



Use of plastics

Companies have begun to understand their role in overuse of plastics with many increasing their efforts to join the circular economy initiative click here to learn more. In Japan the Ministry of Environment has set a 2030 target to reduce single use plastic by 25%.



Modern slavery and supply chains

Many workers in LEDC’s are not paid enough to live above the poverty line. Combine this with poor working conditions and it’s natural to assume a company is exploiting this to increase profits.



Child labour

More than 2 million children are estimated to be working on farms in Côte d’Ivoire and Ghana as 70% of the worlds Cocoa comes from these regions. Chocolate companies recognised the issues back in 2001 and set 2020 as the deadline to reduce the worst of child labour in these regions by 70%.



Antibiotics in our food supply

Antibiotic resistance is estimated to claim the lives of 50,000 people in the US and another 50,000 in Europe in 2019. By 2050 estimations claim that 10 million people globally will die due to antibiotic resistance click here to learn more.

To find out more or register for a free demo, get in touch with our team.