The rise of Environmental, Social and Governance (ESG) concerns
One of the undeniable forces in the investing world in recent years has been the rise of ESG concerns. ESG takes pole position in many asset managers’ marketing materials, mission statements and agendas. Asset flows back up the message; ESG assets across all asset classes rose to $37.8 trillion at year end in 2020 and in 2021 (to 31st July), half of European ETF flows have been to ESG funds.
Source: GSIA, Bloomberg Intelligence
A growing trend
The trend shows no signs of slowing down. Bloomberg Intelligence estimated earlier this year that ESG assets may account for more than a third of the global total AUM by 2025 (assuming a year on year growth rate of 15% – half the average of the last five years).
ESG-themed hedge funds are on the rise
It is safe to say that ESG is here to stay in asset management and is likely to, if it has not already, permeate most sectors of the industry. Alternative investments, and more specifically, hedge funds, are not immune to this trend.
The disparate and varied nature of hedge fund strategies and the assets they trade, as well as their ability to short-sell somewhat ‘muddies the waters’ as far as ESG is concerned; however, this has not prevented hedge funds from adopting the ESG theme. Funds targeting ESG strategies are commonly described as SRI (Socially Responsible Investment) Funds. Over the last three years, assets designated as SRI, by a large undisclosed hedge fund consultant rose from $75bn in September 2018 to $116bn in August 2021; a 55% increase. This may be due to positive performance and increasing flows to SRI designated funds. It may also be due to an increase in the number of funds re-classifying themselves as SRI.
The questions raised by this growing trend
This increase in SRI designated assets in the hedge fund industry gives rise to a number of fundamental questions, perhaps the most pertinent of which are:
- What exactly is the definition of an ‘SRI hedge fund’?
- What key areas should investors focus upon when considering an allocation to hedge funds whilst fully incorporating ESG considerations?
As part of Aurum’s efforts to answer these questions, we refined the list of funds designated as SRI funds into a smaller peer group of funds that we believe can be defensibly classified as ‘ESG’. SRI is a self-designated title – no independent third party verifies this. Most of these funds stop short of fully including ESG in their investment process or objectives, but implement a simple exclusionary screen at the first stage of defining the investible universe. For Aurum to designate a fund as ‘ESG’, we attempted to do what the new SFDR Article 8 and Article 9 Designation intends to do in July 2022. This entailed examining the funds’ documents detailing investment process and criteria, as well as having conversations with managers to ascertain the extent of ESG involvement. This exercise resulted in the initial SRI peer group which contained 138 funds, managing $116bn in assets, being reduced to just 41 Aurum ESG funds managing $11.3bn in assets – an AUM reduction of 90%.
ESG can be incorporated into hedge funds in numerous different ways. Some of the most common ways are:
ESG screening finds those companies that score highly (positive screening) and avoiding those that score lowly (negative screening) on ESG factors, relative to their peers
Aims to identify the most important ESG trends and then use that as the basis for stock-picking; for example, solar energy, online education etc.
Incorporates ESG information into investment decisions in an effort to enhance risk-adjusted returns
Shareholder advocacy and engagement
This is an activist investment approach in which the fund aims to improve companies’ ESG behaviour/metrics through active engagement with management
Looks to invest in those businesses whose activities will target projects or developments that have a positive, measurable benefit to the environment and/or society, alongside a financial return
Aurum’s analysis highlights some of the issues allocators face in this area of alternative investments, namely:
- objectives obfuscation
- lack of transparency
The risks of greenwashing
High definition images of the natural world, feel-good messaging, and convincing communication that ESG is ‘integrated in everything we do’… you get the idea.
The process of conveying a false impression or providing misleading information about how a company’s products are more environmentally sound is commonly known as greenwashing. Given the huge inflows to SRI assets, there is likely to be strong temptation for asset managers to be seen to be green.
Greenwashing covers a slew of behaviours, such as cherry-picking certain ESG metrics and the creation of a narrative to market certain funds as ‘ESG-friendly’ or ‘consistent with ESG principles’. At best, many managers appear to be stretching the definition of ESG to the limit when applying it to their fund. At worst, managers are exploiting investors’ preference for ESG, with no real ESG ‘substance’ when one looks closely.
Greenwashing is prominent, not just in regular corporate communication, but also in asset management and hedge funds. In the Asset Management space, we have seen the recent high level exits of individuals such as Tariq Fancy (ex-BlackRock) and Desiree Fixler (ex-DWS Group) who have been vocal about this. Both of these people became concerned about the legitimacy of their employers’ ESG investment products. You can read more on this in Mr Fancy’s recent essay on the matter.
Investors can help to root out greenwashing
Not all funds with a narrative of ESG-alignment, or a broader objective than absolute returns, are necessarily greenwashing. And herein lies the issue: if investors inadvertently allow some funds to greenwash, effectively rewarding these efforts through subscriptions, the issue becomes self-perpetuating. This is due to the fact that funds with more assets have greater resources at their disposal. Bigger funds are also more likely to come onto the radar of large-ticket allocators such as endowments or Sovereign Wealth Funds.
Reliance merely upon ‘SRI’ designation (or some equivalent) allows certain funds to continue to tick boxes and receive assets intended for ESG funds. The more investors reward this, the more incentivised funds are to engage in greenwashing.
The prudent investor should do the requisite due diligence to negate this issue. Reliance merely upon ‘SRI’ designation (or some equivalent) allows certain funds to continue to tick boxes and receive assets intended for ESG funds. The more investors reward this, the more incentivised funds are to engage in greenwashing. However, if investors begin to dig deeper, beyond the marketing, then greenwashing attempts can potentially be identified and thereby may be damaging to the reputation of those involved.
Greenwashing – the risk for true ESG funds
Funds engaging in greenwashing to gain assets are wielding a double-edged sword. They run the risk of investors becoming more knowledgeable and informed about this issue as media focus grows. If this is allowed to persist, investors will eventually act to penalise this action, which is good, since it polices unsubstantiated ESG messaging.
However, this action carries a risk that investors wanting to avoid greenwashing funds could avoid all funds espousing ESG focus. The knock-on effect? Even legitimate ESG funds could lose out on potential assets.
Marketing SRI funds – a lucrative incentive
SRI funds that have gathered assets partly due to their marketing as ESG hedge funds, are cannibalising potential growth of true ESG funds.
Over the last three years, if we examine hedge funds marketed as SRI that have benefited from the flood of asset inflows to ESG funds, we can see that:
- around 88% of performance fees have gone to those SRI funds that do not fall into the category that we believe can be defensibly classified as Aurum ESG hedge funds
- 4% of performance fees generated have gone to funds that fall into a category that we refer to as ‘NEdge funds’, i.e. not exactly hedge funds
- leaving just 8% of performance fees to Aurum ESG hedge funds
This ‘dollar-pie’ of performance fees actually sums to around $2.1bn over the last three years, meaning non-ESG funds picked up around $1.9bn in performance fees alone.
There is a real opportunity cost for the planet
Some of the true ESG funds have an ‘impact’ element to their return objective. This could be through direct investment in companies best positioned to combat the largest ESG issues and furthering the UN’s Sustainable Development Goals (UN SDGs).
Less investment towards effecting change in the world and potentially advancing the UN SDGs
Consider a $10m investment intended for an ESG hedge fund. If that $10m is allocated to a fund that isn’t a true ESG fund, then that is a $10m opportunity cost reducing investment towards effecting change in the world and advancing the UN SDGs.
In the second part of this series, we examine the obfuscation of investment objectives commonly observed in this segment of the hedge fund industry.