Recognising that purpose and profit are no longer mutually exclusive, a growing number of institutional investors expect hedge fund managers to incorporate environmental, social and governance (or ESG) factors into their investment activities.

We are not yet able to pronounce unequivocally that ESG-compliant investments will lead to better returns. But every indication, from managers and investors alike, suggests that ESG integration is not just increasingly important, but for savvy managers it can go hand-in-hand with generating alpha.

A report published last week by a collaboration of industry partners, including the Alternative Investment Management Association (AIMA), CAIA, CREATE-Research and KPMG, has found that 59% of hedge fund managers are either at the ‘mature’ or ‘in progress’ stage of implementing ESG via appropriate policies, committees, research and data. Having surveyed 135 institutional investors, hedge fund and long-only managers, with combined assets of $6.25 trillion in 13 countries, we have the strongest indication yet that ESG adoption is the committed direction of travel, rather than a temporary tick box. It was pertinent to see this reflected in ESMA’s new sustainable finance strategy, released on the same day. The document set out how ESMA intends to place sustainability at the heart of its regulatory activities by embedding ESG in all its work.

AIMA has been advocating for some time that policy and regulatory decisions around ESG adoption should be investor led, and the data bears that out. Our survey identifies that investor demand is the key driver for 85% of managers in adopting ESG principles into their investment process. AIMA’s ESG DDQ for managers and investors, along with our published guidance for building out policies and procedures, provide the fundamental tools and transparency for investors to gauge the extent of ESG integration amongst managers and how managers can get there.

Significant progress is being made but the scale of adoption remains hampered by the availability of good quality data for managers to assess ESG risk factors.  Our research shows that half of investors and over two-thirds of fund managers surveyed consider one of the biggest hurdles to implementing robust ESG investment strategies is a lack of reliable data that identifies risk and alpha opportunities. The shortcomings in data including inconsistencies in the available methodologies, company disclosures and ratings need to be addressed. For this reason, AIMA’s policy principles call for a regulatory framework that must encompass adequate disclosures from corporate issuers.  

Hedge funds benefit from unrivalled breadth and depth in their talent pool. They are the most flexible investment vehicles around and have an advanced approach to technology and activism. These characteristics of dynamism, innovation and adaptability lay the foundations for hedge funds to identify material signals through consistent data sources and give them a distinct advantage.

One advantage unique to hedge funds is the ability to undertake short selling. A recent paper published by  AIMA explores short selling and how this fits into the framework of responsible investment. Combining short selling and responsible investment is a powerful way to limit systemic risk and drive social and environmental objectives. Short selling and responsible investment are not only compatible—they strengthen each other.

In this spirit, hedge funds have the tools at their disposal to pioneer the development of new approaches that will not only produce more useful and reliable data, but that will shape the future of ESG investment. With investors and managers already united in their determination to overcome what could be seen as the final major barrier, the industry is in a solid position to carve out the way forward.

Hedge funds are very well positioned to benefit from a future defined by ESG, and they are more than capable of overcoming challenges in moving towards full-scale adoption. While certain strategies might not fit simply within an ESG framework the overall direction of travel in the industry is clear and managers are responding actively to meet their clients’ needs.