Dominic Duffy
INSIGHT 07/01/2022

Forget the hedge fund black box… welcome to the world of the green box

Dominic Duffy Investment Associate

In summary…

People often associate hedge fund secrecy with quant funds and the so-called black box[1]… now welcome to the green box.

Hedge funds are inherently private organisations. This is arguably linked to their intellectual property – a proprietary investment process and idiosyncratic strategy. Also, their legal structures and choices of jurisdiction means that they may have fewer disclosure requirements compared to mutual funds.

Sustainable finance disclosure regulation (“SFDR”) aims to tackle clarity and accountability issues, but there are teething issues, leaving many fund managers in the dark when trying to satisfy these new regulations.

The lack of standardisation, or agreement on what ESG investing actually looks like, is clearly a significant hurdle. But with significant due diligence, research and a clear understanding of the issues, these hurdles are not insurmountable.

Difficulties of assessing the impact of ESG hedge funds

Assessment of ESG hedge funds is extremely difficult on two counts:

  1. To what extent do these funds have any impact on the issues they purport to tackle, or at least cause no harm?
  2. To what extent is ESG integrated into the investment decisions?

 

  1. To what extent do these funds have any impact on the issues they purport to tackle, or at least cause no harm?

A recent report[2], produced by Util, examined the impact of US ESG equity funds (i.e. retail, not hedge funds). The report found that much of the ‘impact’ that many of the funds claim to provide is almost non-existent. Although, it also found that investing in general is bad for the environment (the environment is the chief concern for many ESG-minded investors) – which makes the discussion of ESG hedge funds fairly difficult. I note that whilst ESG equity investing was found to be bad for the environment on a net basis, it was marginally less bad than a non-ESG equity investing.

The report also found much of the data underlying ESG ratings of companies to be “insufficient, inconclusive and incomplete”. Furthermore, some of the more interesting findings were that “most ratings don’t measure a company’s impact on ESG factors. They measure the impact of ESG factors on a company’s value” and “Companies are judged on what they say, not what they do.” More transparency and disclosure is needed. Even those ratings for underlying companies display little congruence.

For example, the below analysis from Two Sigma[3] displays the lack of correlation between what constitutes an ESG factor, as defined by major index providers:

Correlation of ESG Index Excess Returns Relative to the MSCI USA Index

Time period: 3rd May, 2010 – 30th October, 2020, using five-day rolling returns

Correlation of ESG Index Excess Returns Relative to the MSCI USA Index

  1. To what extent is ESG integrated into the investment decisions?

This is an area where funds can tout their ESG credentials. We are aware of funds that implement an exclusionary list (i.e. remove certain stocks – deemed to be ‘non-ESG’ – from their investible universe), or state that their investment process has ‘ESG integration’, with the goal of obtaining SRI designation. This allows them to attract ‘ESG-seeking’ assets and potentially also charge a premium on fees.

The need for clarity and accountability

If funds are going to charge a premium, or be allowed to ride the wave of inflows to ESG assets, they must disclose the extent to which ESG is actually integrated, and illustrate with examples. There needs to be ongoing accountability and clearly defined, transparent, measurable goals.

This area of the investment process will need to become more transparent for investors to gain comfort. Of course, this does not extend to those funds employing ESG-linked strategies via proprietary models, but an insight into the effect ESG integration has on the fund is necessary.

Sustainable finance disclosure regulation (“SFDR”)

The SFDR is the first set of regulations under the EU’s Action Plan for financing sustainable growth. And indeed the first global regulatory standard which aims to harmonise an ESG framework to prevent greenwashing. The aim of the SFDR is to increase transparency by imposing sustainability disclosure requirements on investment management firms. These are required to be made at both the product and manager level and include equity indicator disclosure requirements.

To adhere to SFDR and achieve a sustainable fund designation is a taxing affair for fund managers in terms of resources required (and is therefore disproportionately damaging for smaller managers) and the lack of technical detail provided by the SFDR or regulatory guidance makes the process that much harder for them. However, at present, for those funds that wish to undertake activity in Europe it is a necessary hurdle to managers designating themselves as ‘ESG’. Whilst there is no prescribed sanctions regime, under SFDR the regulation relies on existing powers of regulators and courts to put punitive measures on managers who claim compliance with SFDR but are unable to provide the required disclosures.

However, there are further issues with SFDR in its current format:

  • It focuses on equities, not other asset classes
  • It fails to properly account for activist investors
  • The data for the benchmarks is not adequate for the standards laid out, undermining the goal of SFDR
  • Some investors will use proprietary ESG measures for SFDR purposes, undermining the objectives and obfuscating the ‘transparency’ goal
  • Many terms are undefined, giving a wide range of interpretation and implementation, among both investors and regulators
  • It takes a quite restrictive approach to defining the different letters of ESG. For example, social and environmental characteristics only recognise the following activities:
    1. Climate change mitigation
    2. Climate change adaptation
    3. Sustainable use and protection of water and marine resources
    4. Transition to a circular economy
    5. Pollution and restoration of biodiversity and ecosystems
    6. Protection and restoration of biodiversity and ecosystems
  • Note that this lacks any consideration of education, alleviating poverty, research into clean technology or access to healthcare, as well as numerous other activities

As standardisation improves and data/service providers also adjust to this new market opportunity, funds seeking SFDR ESG designation will undoubtedly find it easier to satisfy disclosures.

Until these regulations have had time to become embedded into market practice and have regulatory clarity, fund managers trying to satisfy the new content, methodology and disclosures regulations are working in the dark. When this is considered on top of a paucity of ESG data from both issuers and ESG data firms, the compounding effect of this lack of transparency becomes substantial.

Conclusion

Hedge funds that pay proper regard to ESG do exist, but at present, investors must look further than simply checking the funds designations or fancy marketing materials. Allocators must look ‘under the bonnet’ in order to fully understand, monitor and quantify how ESG is integrated and what ‘success’ looks like. Classifications and standardisation will undoubtedly improve over time, but until such time that they are sufficient, the work falls to investors.

Hedge funds that pay proper regard to ESG do exist, but at present, investors must look further than simply checking the funds designations or fancy marketing materials.

I do not want to appear overly gloomy, many of the issues discussed in this report are becoming a greater subject of focus and debate; as such the situation is undoubtedly improving. For example, the implementation of SFDR will give funds a framework to distinguish their ESG credentials.

There is still some ambiguity between practitioners as to what distinguishes the different classifications; these classifications relate mostly to the reporting standards of a fund, rather than the strategy of the fund. Further, these onerous reporting requirements will present more of an impediment for smaller managers and those with high portfolio turnover – such as many hedge fund strategies.

The lack of standardisation, or agreement on what ESG investing actually looks like, is clearly a significant hurdle. But with significant due diligence, research and a clear understanding of the issues, these hurdles are not insurmountable.

As such, investors must not fool themselves into thinking they have done their bit for the planet by divesting from traditional funds and into so-called ‘ESG funds’.

The issue of ESG couldn’t be more topical. Environmental issues by their very nature are exponential, hence the impact can be hard for the human mind to fully appreciate, but the consequences of inaction are extremely grave.

Hot off the heels of the COP26 meeting, following on from an IPCC report earlier this year calling for immediate action, urgency is required, not tokenism.

 

1 https://www.investopedia.com/terms/b/blackbox.asp

2 https://uploads-ssl.webflow.com/5cf4f70073a623716fb74c59/614c7813194a097955433eb5_Util%20Report%20How%20SDG%20is%20ESG%3F%20.pdf

3 https://www.twosigma.com/articles/what-is-esg-depends-on-whom-you-ask/