Insight

Doing good and maximising returns

Aurum Research Limited
14/12/2021
4 min read
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In summary…

Hedge funds that pay proper regard to ESG do exist, but at present, investors need to look ‘under the bonnet’ in order to fully understand, monitor and quantify how ESG is integrated.

Hedge fund managers that aim to both achieve benefits beyond mere financial gains and to maximise returns run the risk that they fail to deliver on either. This is because excluding certain investments and imposing restrictions on what a strategy can and cannot do potentially sacrifices additional returns.

Funds that implement a simple exclusion list are clearly reducing their opportunity set. Conversely according to a 2019 paper by MSCI, funds that integrate ESG in an intelligent, tail risk-orientated manner potentially enhance their investment process.

To help allocators make an informed decision, ESG fund strategies and objectives need to be clearly defined and evaluated.

Questioning ESG hedge fund marketing

The marketing of ESG hedge funds tends to go in one of two directions, both of which leave unanswered questions for investors:

  1. Firstly, there are those funds that aim to both achieve benefits beyond mere financial gains and maximise returns, by following an exclusionary ESG strategy. The usual argument goes as follows:

ESG issues pose a substantial risk to company fundamentals and by incorporating ESG factors into the investment decision, investors are actually enhancing their investment process to such a degree that they:

a) avoid potentially poor investments, which are subject to ESG risks and resultantly punished by investors; and

b) are able to benefit from investments in companies that stand to benefit from a systemic shift away from firms that are expected to struggle in a world that embraces ESG investment principals. Or where certain environmental factors are perceived to directly impact company fundamentals.

If investing in a virtuous manner was additive to risk-adjusted returns, then any rational, returns-maximising investor would do so. However, the relative youth of this brand of investing makes it hard to empirically support this claim. ESG funds often claim they can outperform due to their focus on and inclusion of ESG issues, but only after a reasonable time period (ideally a full market cycle, but arbitrarily 5-10 years) can this claim be assessed. However, the introduction of hard ESG parameters into the investment decision limits the search space and, therefore, a manager’s opportunity set. Additionally, ESG investing faces other headwinds (which we will explore in Part 3 of this series) which limits the efficacy of this theorem.
If investing in a virtuous manner was additive to risk-adjusted returns, then any rational, returns-maximising investor would do so.

  1. Then there are those funds that claim they are not maximising returns, but rather that they are balancing their investments between both ‘achieving benefits beyond financial gains’ and generating returns. The issue here is that little clarity is available on the measurement and evaluation of impact on ‘doing good’ be it the UN’s Social Development Goals (“SDG”) or other relevant goals. Hedge funds need to be fully accountable, and the definition of ‘success’ needs to be carefully and clearly communicated and understood prior to allocating capital to an ESG fund.

ESG performance

To analyse if ESG funds outperform, we have looked at returns of three different groups over the last three years. Equity Long/Short strategy returns were used for comparison as it is the most populous master strategy within the hedge fund universe, as well as in both the SRI, and true ESG, peer groups.

The chart below compares the performance of non-SRI equity long/short funds (‘Non-SRI’), those that Aurum consider to be ESG funds (‘Aurum ESG’) and self-designated SRI funds (‘SRI’). Upon initial inspection, it appears that Aurum ESG funds do indeed outperform, by 13% cumulatively over the last three years.

Source: Aurum Hedge Fund Data Engine[1]

Upon initial inspection, it may appear that ESG funds do indeed outperform, to the tune of around 13% over the last three years cumulatively.

However, we must contextualise these returns. Most of these long/short funds in all categories maintain some kind of a long bias, only a small minority employ low net, or even market neutral, investment strategies. As such, with the considerable equity market tailwind of the last three years, it should be no surprise that these funds have provided decent gains. For context, over the same period, Global Equities[2] gained 37%.

Increasing investors’ equity risk

These ESG equity long/short funds usually represent levered exposure to global equity markets, thereby substantially increasing the risk profile of an investor who already has allocations to equities. Also, investors should be wary of which factors they are boosting their exposure to – clean tech equities tend to exhibit a growth/momentum bias, and many equities that are chosen through ESG metrics exhibit a great deal of quality bias[3].

The majority of true ESG funds employ some kind of equity long/short strategy, which given their limitation to one asset class, and a subset of that asset class at that also makes it nearly impossible to create a high quality, truly diversified portfolio of hedge funds with the current market offering.

Conclusion

Hedge funds that pay proper regard to ESG do exist and those managers integrating ESG in an intelligent, tail risk-orientated manner could potentially enhance their investment process[4]. However, allocators need to fully understand the strategy of the funds they are considering and analyse any impact the investment may have on their overall portfolio diversification, equity weighting and portfolio factor risk.

In the final part of this series, we will look at the need for transparency and accountability.

  1. Aurum Hedge Fund Data Engine database containing data on just under 4,000 hedge funds representing in excess of $2.9 trillion of assets as at December 2020. Information in the database is derived from multiple sources including Aurum’s own research, regulatory filings, public registers and other database providers.

  2. S&P Global BMI

  3. https://www.ft.com/content/be140b1b-2249-4dd9-859c-3f8f12ce6036

  4. https://www.msci.com/documents/10199/9aec76d8-376f-91ef-a575-b2b0ea65061a

The S&P Global BMI (the “S&P Index”) is a product of S&P Dow Jones Indices LLC, its affiliates and/or their licensors and has been licensed for use by Aurum Research Limited. Copyright © 2021 S&P Dow Jones Indices LLC, its affiliates and/or their licensors. All rights reserved. Redistribution or reproduction in whole or in part are prohibited without written permission of S&P Dow Jones Indices LLC. For more information on any of S&P Dow Jones Indices LLC’s indices please visit www.spdji.com. S&P® is a registered trademark of Standard & Poor’s Financial Services LLC and Dow Jones® is a registered trademark of Dow Jones Trademark Holdings LLC. Neither S&P Dow Jones Indices LLC, Dow Jones Trademark Holdings LLC, their affiliates nor their third party licensors make any representation or warranty, express or implied, as to the ability of any index to accurately represent the asset class or market sector that it purports to represent and neither S&P Dow Jones Indices LLC, Dow Jones Trademark Holdings LLC, their affiliates nor their third party licensors shall have any liability for any errors, omissions, or interruptions of any index or the data included therein.

By accepting delivery of this Paper, the reader: (a) agrees it will not extract any index values from the Paper nor will it store, reproduce or further distribute the index values to any third party for any purpose in any format or by any means except that reader may store the Paper for its personal, non-commercial use; (b) acknowledges and agrees that S&P own the S&P Index, the associated index values and all intellectual property therein and (c) S&P disclaims any and all warranties and representations with respect to the S&P Index.

Disclaimer

This Post represents the views of the author and their own economic research and analysis. These views do not necessarily reflect the views of Aurum Fund Management Ltd. This Post does not constitute an offer to sell or a solicitation of an offer to buy or an endorsement of any interest in an Aurum Fund or any other fund, or an endorsement for any particular trade, trading strategy or market. This Post is directed at persons having professional experience in matters relating to investments in unregulated collective investment schemes, and should only be used by such persons or investment professionals. Hedge Funds may employ trading methods which risk substantial or complete loss of any amounts invested. The value of your investment and the income you get may go down as well as up. Any performance figures quoted refer to the past and past performance is not a guarantee of future performance or a reliable indicator of future results. Returns may also increase or decrease as a result of currency fluctuations. An investment such as those described in this Post should be regarded as speculative and should not be used as a complete investment programme. This Post is for informational purposes only and not to be relied upon as investment, legal, tax, or financial advice. Whilst the information contained in this Post (including any expression of opinion or forecast) has been obtained from, or is based on, sources believed by Aurum to be reliable, it is not guaranteed as to its accuracy or completeness. This Post is current only at the date it was first published and may no longer be true or complete when viewed by the reader. This Post is provided without obligation on the part of Aurum and its associated companies and on the understanding that any persons who acting upon it or changes their investment position in reliance on it does so entirely at their own risk. In no event will Aurum or any of its associated companies be liable to any person for any direct, indirect, special or consequential damages arising out of any use or reliance on this Post, even if Aurum is expressly advised of the possibility or likelihood of such damages.

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