In February 2018, I had the pleasure of joining several esteemed panelists on stage at the 2018 Cayman Alternative Investment Summit (CAIS) to discuss hedge funds and the future of investing. It didn’t take long for us to reach a consensus: responsible investment is here to stay.
Perhaps this may come as a surprise to some in the hedge fund community. After all, the premise of hedge funds is that they are not constrained in the investments they can make. Hedge fund managers value that flexibility, and some have even expressed concerns that adopting responsible investment principles could hurt their ability to protect and grow the capital of their investors.
However, as we found in our recent paper on the future of the hedge fund industry, Perspectives, 1 hedge fund firms have always embraced change and responded to investor demand. Responsible investment is no exception to this rule. Hedge fund firms realize that today’s investors, be they institutions or individuals, expect to see their principles reflected in their investments. As a result, hedge fund firms are beginning to implement responsible investment, be it through the screening of certain securities, the analysis of environmental, social, and governance factors, or even through impact investing.
While some hedge fund firms are skeptical about how practical it is to implement a responsible investment strategy, the conversations I’ve had with leaders across the industry reveal a different story. Instead of focusing on the question of whether to adopt responsible investment, a significant number of hedge fund firms are now focusing on how to adopt responsible investment while continuing to deliver the strong risk-adjusted returns that their investors have come to expect.
This work is even more important in light of the recent sustainable finance legislative proposals unveiled by the EU aimed at harnessing the capital markets to help implement the 2015 Paris Agreement. Among the proposals put forward by the EU include a regulation requiring the disclosure of the procedures and conditions applied by financial participants, including asset managers, for integrating sustainability risks in investment decisions.2 Certainly, there are still challenges to overcome before responsible investment can become more widely adopted across the hedge fund industry. The first step to overcoming those challenges is understanding how hedge funds currently view and approach responsible investment.
In order to gain that understanding, the Alternative Investment Management Association (AIMA) and CAIS commissioned a survey of hedge fund firms that in aggregate manage an estimated $550 billion in total assets.
The results of that exercise can be found in this report, From Niche to Mainstream: Responsible Investment and Hedge Funds. We found that while we are still in the early days of hedge fund firms embracing responsible investment, there is a groundswell of pressure—both from investors and industry leaders—to act and enter this space.
Jack Inglis, CEO, AIMA
Chief Executive Officer, AIMA
Responsible investment goes mainstream
Increasing investor demand for responsible investment is one of the biggest trends shaping the global asset management industry today. Investors are increasingly demanding portfolio solutions that, as well as minimising risks and maximising returns, also take social and environmental concerns into account.
As measured by the population of the 80 hedge fund firms that reported to this survey, at least $59 billion in hedge fund assets is currently being managed under responsible investment principles.3 Meanwhile, fully 51% of hedge fund firms surveyed reported increased investor interest in responsible investment over the past 12 months, with interest particularly strong in North America, a region that has traditionally been more hesitant to embrace responsible investment.
Big or small, hedge fund firms are adopting responsible investment
Responsible investment is not merely the preserve of the largest of hedge fund firms: smaller firms are embracing it as well. 40% of all hedge fund firms surveyed currently practice responsible investment in some form. This trend encompasses hedge fund firms of different sizes, with 60% of the larger hedge fund firms ($1+ billion in assets under management) surveyed saying they practice responsible investment, versus 23% of smaller firms (<$100 million in assets under management). As the number of smaller firms that practice responsible investment grows, the assets being managed under responsible investment principles will expand. It follows then that the adoption of responsible investment is a permanent, structural trend across the hedge fund industry.
Signed, sealed, and delivering responsible investment
Hedge fund firms are increasingly opting to sign the United Nations-backed Principles for Responsible Investment (UN PRI). 36% of hedge fund firms surveyed have already signed the UN PRI, or say they plan to do so. Related to this, 38% of all hedge fund firms surveyed are either already using the UN PRI due diligence questionnaire template during the due diligence process with investors, or plan to begin using it. This is further evidence that responsible investment is becoming top-of-mind for investors, who want to better understand each hedge fund firm’s governance and investment processes, including the monitoring and reporting that is needed for a hedge fund firm practicing responsible investment.
Investing in responsible investment
Nearly a third of all hedge fund firms surveyed have hired a responsible investment expert, or plan to make a hire in this area over the next 12 months. Hedge fund firms' investment in human capital is the strongest sign yet of the hedge fund industry’s commitment to understanding responsible investment and evaluating how best to incorporate it into their investment strategies.
Adoption of responsible investment runs deep…
One in five hedge fund firms surveyed reported having over 50% of their total investment capital being managed under responsible investment principles. Investors now have the opportunity to allocate to firms that embed responsible investment in every investment decision they make.
…but challenges remain
The two most common challenges cited by hedge fund firms surveyed are “inadequate methodologies for the calculation of sustainability risks” and the “lack of relevant disclosures from companies.” Without companies publicly disclosing quality data that shows their performance on ESG issues, many managers will be hard-pressed to find a way to evaluate the social and environmental and governance attributes of a potential investment. However, as hedge fund firms continue to build out their responsible investment infrastructure, and as more companies release information on how they perform on ESG factors, these challenges are likely to be overcome.
Principles for Responsible Investment
"The United Nations-supported Principles for Responsible Investment welcomes this piece of research by the Alternative Investment Management Association (AIMA) and the Cayman Alternative Investment Summit (CAIS). Hedge fund firms form an important part of the global asset management industry, and their contributions to responsible investment will help ensure that asset management is both socially responsible and environmentally sustainable. The United Nations Principles for Responsible Investment looks forward to working with AIMA, CAIS, and others to help the make that goal a reality." UN PRI
United Nations Principles for Responsible Investment (UN PRI): a set of six investment principles that offer signatories actions for integrating responsible investment into their investment decisions.
» Principle 1: We will incorporate ESG issues into investment analysis and decision-making processes.
» Principle 2: We will be active owners and incorporate ESG issues into our ownership policies and practices.
» Principle 3: We will seek appropriate disclosure on ESG issues by the entities in which we invest.
» Principle 4: We will promote acceptance and implementation of the Principles within the investment industry.
» Principle 5: We will work together to enhance our effectiveness in implementing the Principles.
» Principle 6: We will each report on our activities and progress towards.
To learn more or to become a signatory, please visit www.unpri.org.
Responsible investment is today one of the biggest trends reshaping the global asset management industry.
While there is debate within the industry about what exactly can and should be labeled a “responsible investment” (see page 12), experts agree that interest in this area—and consequently capital allocations—is likely to grow.
According to the 2016 Global Sustainable Review, at the start of 2016 there were $22.89 trillion in global assets being professionally managed via responsible investment strategies. This represents approximately a quarter of total assets being managed by the global asset management industry, and an increase of 25% since the previous estimate was collated in 2014. Just over half of that $22.89 trillion is being managed by asset management firms located in Europe; roughly 36% is being managed by firms in the United States.
While these numbers include responsible investment strategies with varying degrees of robustness, they suggest that responsible investment is not a short-term trend, but rather a permanent shift in philosophy across the asset management industry. They also suggest that there is substantial capacity for growth in this space across the rest of the world as interest in responsible investment continues to grow.
Many of the world’s largest asset managers are responding to this shift by restructuring their businesses and investment strategies in order to embrace responsible investment. There are two primary reasons for this shift: demographics are changing and investors are increasingly demanding access to responsible investment strategies, and some recent research has pointed to evidence that responsible investment may boost risk-adjusted financial returns.
Will Hedge Funds Follow?
Will the Hedge Fund Industry Follow the Same Path?
Based on the responses to the survey and the ensuing conversations we held with firms and investors, we believe the answer appears to be yes. In analyzing the survey results, we found that just over half of the hedge fund firms surveyed are seeing increased interest in their responsible investment capabilities from current or prospective investors. In meeting this demand, about 40% of respondents said that they are currently investing using responsible investment principles, including 20% who are committing at least 50% of their firms' assets under management to responsible investment strategies.
The results indicate that there is approximately $59 billion in total hedge fund assets allocated to responsible investments among the survey population.
Increasingly, many hedge fund investors want more than just financial returns—they want social and environmental returns as well. However, accounting for those considerations without sacrificing financial performance is still seen as a challenge by some hedge fund managers, and is a reason cited by some for delaying their adoption of responsible investment.
51% of respondents are seeing increased interest in their responsible investment (RI) capabilities from current or prospective investors
40% of respondents are currently allocating to responsible investments, representing $59 billion in total assets allocated to responsible investments
The Tide is Turning
BlackRock CEO Larry Fink wrote in his 2017 annual letter to CEOs: “Society is demanding that companies, both public and private, serve a social purpose. To prosper over time, every company must not only deliver financial performance, but also show how it makes a positive contribution to society.”
This industry-shaking proclamation put not only public and private companies on notice, but also the asset managers that invest in those companies. While the hedge fund industry has been relatively slow to adopt responsible investment compared to other sectors of the asset management industry, the tide is turning. Several hedge fund firms have recently launched funds that employ a responsible investment focus.
In January 2018, Jana Partners launched the Jana Impact Fund to invest in companies the hedge fund “believes are good bets but could do better for the world.”
Also in January, ValueAct Capital launched the ValueAct Spring Fund, which will invest in companies that are “emphasizing and addressing environmental and societal problems.” In his letter to investors, ValueAct founder Jeff Uben specifically pointed to the potential for “excess return” by investing in these companies.9 In April, Avenue Capital announced plans to launch a credit fund that will make impact investments in businesses that have a strong social or environmental impact, such as those in sectors like renewable energy, affordable housing and infrastructure resiliency.
This is only the beginning. More managers will likely follow as the market matures and interest grows. What is clear is that the hedge fund industry as a whole is beginning to embrace its potential beyond generating financial returns by helping to lead the fight to build a socially and environmentally responsible world.
How will hedge fund firms adapt to the growing demand, and what challenges still remain for those looking to adopt responsible investment?
The answers to these and other questions are the subject of this report.
Tony Cowell, Partner, Head of Asset Management for KPMG Cayman Islands & Co-Chair of the Editorial Committee for CAIS
From Niche to Mainstream: Responsible Investment and Hedge Funds
Download the full report here