This discussion paper describes the characteristics of hedge funds and discusses the advantages and risks associated with the different techniques and instruments used within hedge fund investing. It talks about some actions hedge fund investors can take to improve the governance of hedge funds. It also highlights responsible investment practices that can be implemented within distinctive hedge fund strategies. It concludes by drawing attention to concrete actions that asset owners can take to build relationships with their hedge fund managers in order to address responsible investment issues and challenges.

Responsible investment practices in hedge funds

Ensure robust governance of hedge funds and of the relationship between the investor and the hedge fund manager.
Consider the relevance of ESG data to research before investment decisions are made. This will be applicable in hedge fund strategies that involve fundamental analysis and security selection.
Understand the concept of active and responsible ownership (first and foremost in the context of voting rights and engagement with corporate management). This will apply in strategies that involve holding long equity positions for a reasonable period of time. There are also factors to be taken into consideration in the context of borrowing and shorting stock, and in specific fixed income situations.
Recognise the benefits and manage the risks for a hedge fund associated with the use of specific instruments and techniques – such as shorting, leverage, derivatives and high frequency trading.
Identify the benefits and manage the risks that particular strategies might present for other parts of an investor’s portfolio and for the market broadly.
Maintain good stakeholder relationships by understanding and managing the issues that are of concern to particular stakeholders, such as state actors.
Clear communication regarding your responsible investment expectations between asset owners and investment managers, culminating in a formal policy. Specific actions that asset owners and hedge fund managers can take are set out in the sections on hedge fund instruments and strategies.

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Responsible investment hedge funds: Discussion paper

March 2012

Executive summary

Governance

Directors

As part of due diligence, investors can look into the background, role, contribution and oversight functions of the independent directors as well as the board’s overall governance structure. A starting point would be to ensure good, competent and independent directors are appointed to the boards of hedge funds. Investors could expect a majority of independent directors with requisite skills-sets and experiences to be appointed to all boards including an independent chair.

Transparency

Investors could require as much transparency as necessary to enable prudent due diligence, risk analysis and monitoring of portfolios. Investors could expect hedge fund managers to clearly and transparently disclose all details of the fund governance structure, including all fund terms and conditions. They can also support ongoing collaborative initiatives to foster greater transparency such as OP.

Techniques and instruments

Short selling

Significant amounts of research by academics and regulators have been undertaken in the hope of reaching unbiased conclusions on the impacts of shorting.9 Broadly, this research has supported short selling as a legitimate activity that is an integral part of efficient and well-functioning markets. However, investors may seek to familiarise themselves with the technique of shorting and ensure that they understand the investment strategy of the manager with regard to shorting and potential market implications.

Leverage

It is important that asset owners are aware of the possible implications of leverage used by hedge fund managers.

Investors may seek to ensure before investing that they understand how leverage will be used in the fund, maximum leverage levels the fund proposes to use, and the implications for their investment in various market scenarios. The key metric for the most investors will be the difference between the amount of capital invested and the amount that could be lost. Investors could satisfy themselves that managers have procedures in place to accurately evaluate, monitor and limit economic leverage, financial leverage, derivative exposure and counterparty risk (which is inherent in many forms of leverage).

Investors could also ensure that they understand the implications of failure to manage leverage across the market as a whole, and the relationship between their own investment and this broader concern.

Derivatives

Asset owners may seek to ensure that they fully understand the implications of a fund’s use of derivatives, including the counterparty and other risks that might arise in extreme situations. They may also seek to ensure that managers have adequate procedures to mitigate and manage these risks. Investors may want to be aware of and understand the impacts of regulatory initiatives that will likely change the OTC derivatives industry.

High frequency trading

Hedge funds account for only a relatively small proportion of total HFT in the market.15 Nonetheless, this may still be a concern that investors wish to consider. Asset owners may seek to ensure that they understand the implications of the trading strategies used by hedge funds, both for the fund itself and for the market more broadly and their portfolio as a whole.

Strategies

Fundamental selection, equity or credit long/short

When a hedge fund manager engages in a fundamental analysis and selection process, ESG risks and opportunities can and should be identified as an integral part of the analysis and then appropriately weighed and managed. Emerging markets may have less developed legal and regulatory protections relating to the management of ESG issues and therefore warrant a higher degree of attention. Investors may want to ensure that managers whose strategies include fundamental selection in emerging markets support or endorse international standards for governance, transparency and regulatory improvements.

Investment managers who hold significant long equity positions for reasonable amounts of time could have voting policies and might be expected to conduct engagement with corporate management.

Investors could seek to restrict the activity of borrowing shares for the purpose of voting. Some investors may wish to avoid strategies that include large directional bets on a stock’s decline, or naked shorting.

Relative value, arbitrage and volatility

Asset owners may seek to ensure that they fully understand the types of information hedge fund manager’s use in relative value, arbitrage and volatility strategies, and whether they have explored the potential for ESG data to add value. Investment managers are encouraged to undertake research of this kind. If high frequency trading strategies are used, asset owners could also ensure that they understand the implications on the fund itself and for the market more broadly and their portfolio as a whole.

Event-driven, corporate distressed, bankruptcy, restructuring

Investors may want to ensure that no form of improper pressure or coercion is applied by the hedge fund manager in distressed investing situations, including seeking to claim shareholder rights through positions in derivatives, and in strategies involving residential foreclosure.

Global macro, multi-strategy and global tactical asset allocation

The use of ESG data may be relevant in the composition of equity and credit indices and in country risk analysis in macro strategies.

When a manager uses multiple strategies, investors could focus on the main strategy (strategies) and apply relevant responsible investment practices as appropriate.

Foreign exchange

Investors may wish to develop a policy to conduct enhanced due diligence if it is believed that a strategy which takes positions in currencies (or sovereign debt) has the potential to affect the fortunes of an economy at a time of vulnerability if the strategy is widely pursued by a range of managers.

Fixed income: government and supranational

Some investors may wish to discuss sovereign bond restrictions with a hedge fund manager, preventing investments in the bonds of a country subject to, for example, UN Security Council sanctions. Some investors may want to avoid strategies which could be seen as exploiting the sovereign debt of developing countries.

Mortgages, ABS, specialised credit and financial services

Investors may wish to ensure that managers who actively participate in servicing and collection strategies in personal or mortgage debt comply with fair lending laws. They may also want to seek some assurance from hedge fund managers about their relationship and agreements with third parties providing these servicing and collection services.

Investors may seek full disclosure from the fund manager in relation to all parties involved in structuring securities, and on any position the issuer has itself taken in relation to the securities.

Some investors may wish to avoid traded life strategies.

Commodities

The commodities asset class is fundamentally linked with ESG issues. However, the ESG issues that need to be considered vary depending on the type of investment. Investors could have an understanding of the ESG issues involved with exposure to commodities through real productive assets, debt or equity investments, physical commodities (direct or indirect) or commodity derivatives. Investors may want to understand if and how physical and derivatives investments can impact the functioning of markets and the sustainable development of economies.

Private equity

Hedge funds can and do invest in private equity. While ownership structures and governance differ between public and private equity, the underlying asset in which they invest is the same – a company. The information and analysis needed to identify and manage material ESG risks and opportunities is the same in public and private equity.

The relationship between the asset owner an the hedge fund manager

Explain why responsible investment practices are important for your portfolio.
Communicate your specific expectations before investment.
Assess the manager’s ability to meet your requirements.
Use formal mechanisms to implement ESG requests.
Ensure a sufficient level of legal rigour around your responsible investment requests.
Ensure an agreed responsible investment policy.
Ensure capacity to monitor and report.
Ensure the consequences of a breach are understood.