Hedge funds start integrating ESG

By Jeremy Siegel, Portfolio BI

Published: 22 March 2021

While 2020 was a disruptive year for many financial institutions, it was a positive one for asset managers running ESG (environment, social, governance) strategies. This is because COVID-19 prompted investors to think more carefully about sustainability, a by-product of which was that ESG funds attracted increased net inflows - totalling  $71.1 billion between April and June 2020 - thrusting their global AuM (assets under Management) past $1 trillion.[1] In the US, sustainable funds    amassed a record $21.4 billion during the whole of 2019, but last year’s fundraising efforts had already exceeded that amount by September – after accumulating $30.7 billion. [2]  Hedge funds are also becoming more active around sustainability issues, although they have been slower than traditional asset managers to integrate ESG into their investment processes.  A survey by BNP Paribas of 53 hedge funds running more than $500 billion in combined AuM found 40% of managers include ESG considerations in their investment processes, whereas the rest do not. However, the BNP Paribas study added that it anticipated most hedge funds will adopt ESG approaches by 2022.[3]

ESG funds put in a powerful performance

Countless columns have been devoted to hypothesising about whether ESG funds outperform non-ESG funds or not. Sceptics have repeatedly attested that there is insufficient historical data to evidence any outperformance by ESG managers, although recent analysis by Morningstar revealed that close to 60% of sustainable funds have delivered higher returns than their opposite conventional fund numbers over the last 10 years.[4] ESG hedge funds have also produced solid returns over the last 12 months in what should strengthen their appeal among global institutions.

It is highly likely that there will be a significant jump in the number of hedge funds launching ESG strategies over the next 12 months, mainly because of rising institutional demand for sustainable investment products. A study by PwC found 77% of European investors – including pension funds and insurance companies - intend to stop using non-ESG investment strategies by 2022. European investors are widely considered to be ahead of the curve when it comes to ESG, at least when benchmarked against US allocators. Whereas four in 10 European and Asian pension funds have pledged to meet net zero carbon emissions by 2050, only one in five US schemes has made a similar commitment. [5] However, attitudes towards ESG among US institutions seem to be slowly changing

A study undertaken by the Financial Planning Association in 2018 found 26% of financial professionals were either using or recommending ESG funds to clients. The same survey conducted in 2020 revealed this percentage had increased to 38%. Several high profile US institutions – including the likes of CALPERS and Wespath - have signed up to the UN-backed Net Zero Asset Owner Alliance, a consortium comprised of 30 of the world’s largest investors – all of whom have committed to reduce carbon emissions linked to the companies they invest in by 29% within the next four years. [6] In January 2021, two of the five pension funds in the New York City Retirement Systems confirmed they would divest $4 billion from securities linked to fossil fuels. A failure to transition towards net zero is a pertinent risk management issue, a point made by Larry Fink, CEO at BlackRock in a recent investor letter. In the letter, Fink warned that those companies failing to adapt or transition towards net zero would see their businesses and valuations suffer. It is clear that more global investors are now prioritising ESG, and it is something which hedge funds need to respond to.

Regulators make their case on ESG

Regulation of ESG is becoming increasingly ubiquitous across a number of global markets. Again, the leaders here are widely acknowledged to be the EU, which will introduce a Sustainable Finance Disclosure Regulation (SFDR) rule  in March 2021, forcing asset managers and asset owners to publish on their websites information on how they integrate ESG into their investment activities. From next year, EU regulators will demand that managers specialising in ESG and sustainability file a very detailed template outlining their ESG practices. The EU rules will also create a taxonomy as regulators look to facilitate greater consistency in terms of what can be classified as being a sustainable economic activity. The taxonomy comes amid investor and regulatory concerns about green-washing (e.g. a lack of clear sustainable investment definitions) at fund managers. This is evidenced in a Schroders study, which found that around 60% of investors identified green-washing as being one of the most significant obstacles impeding their sustainable investment intentions.

In contrast, US regulation on ESG investing has been fragmented. A number of states including California, Illinois, Connecticut, New Jersey, New York, Oregon and Washington are pushing through with requirements designed to encourage their public pension funds to invest more sustainably. However, the Department of Labor (DOL) – under the previous US administration – introduced a rule in October 2020 demanding pension funds prioritise financial returns when making asset allocations - as opposed to ESG criteria. Despite this, the new US administration is putting an enormous emphasis on the environment, suggesting there will now be a much greater focus on ESG investing.

Data continues to be a barrier

However, there are concerns about the quality of ESG data being disclosed by managers to their investors. One of the primary problems is that there are no harmonised ESG data standards. Instead, there are many different ESG standards and protocols, all of which have their own characteristics. With different managers subscribing to different ESG standards, the reports they produce for clients are often inconsistent and even contradictory. Similarly, ratings agencies will often have their own bespoke methods of collecting data from companies they are scoring. For instance, some ratings agencies will solely rely on questionnaires while others will only use publicly available information. Without a common data collection methodology, the ratings agencies’ scoring processes will be fragmented. It is vital hedge funds work together towards improving ESG data quality and standards.

 ESG: The future of investing

Hedge funds are embracing ESG for several reasons. Many have now accepted that the performance benefits of investing in ESG securities and assets are worthwhile. With more institutional investors incorporating ESG criteria into their selection processes, firms will need to take note if they are to successfully attract mandates. At the same time, regulators – including those in the US – are expected to be more proactive on ESG - in what could help further accelerate flows into ESG funds.



[1] Morningstar analytics

[2] Morningstar analytics

[3] BNP Paribas (October 28, 2020) Where are hedge funds on the ESG spectrum?

[4] Financial Times (June 13, 2020) Majority of ESG funds outperform the wider market over 10 years

[5] AI CIO

[6] Financial Times