By Marisol Hernandez (@Mary_Hdez), Head of Asset Owners, PRI
Hedge funds must contribute meaningfully to the investment challenges presented by COVID-19 and the climate crisis
Read ESG incorporation in hedge funds technical guide
The ongoing COVID-19 and climate crises are having significant impact, not only on our health but also on our food, water supplies, security, as well as ecosystems, livelihoods, and economic growth.
If anything, the abruptness of the COVID-19 crisis is a reminder of how potentially disruptive emerging environmental and social risks can be – through their systemic nature, their global dimensions, the unprecedented policy responses they require and the tumultuous economic consequences they can have.
After any crisis, there is a recovery period, and investors will be presented with a unique opportunity to rebuild and repair all sectors of the economy, from farming to finance. Hedge fund managers are no exception to this.
A tricky history
Hedge funds haven’t always enjoyed a good reputation, and many are sceptical about whether they can embrace responsible investment practices.
However, since the 2008 financial crisis, hedge fund managers have strengthened their governance structures considerably, the regulatory[1] scrutiny they face has increased, and they have played an important role providing liquidity, particularly in times of market stress, with strategies focused on private or distressed debt or event-driven and special situations helping to restructure and rescue companies, including those in the cleantech and renewable sectors.
More opportunities than barriers
Contributing to a recovering global economy means investing in a way that reallocates capital towards more sustainable business models, rather than simply chasing alpha, or managing beta. There are more opportunities than barriers for hedge fund managers to act:
- Engagement and stewardship: Hedge fund managers are among the most active money managers in the finance sector. They can make sure the businesses they invest in are fit for purpose while including ESG conditions to drive operational improvements – from the supply chain to the end customer – to ensure these investments don’t represent a cost for society and the environment.
- Transparency: Linked to this engagement, hedge fund managers can and should push for better disclosure and accountability in the responsible investment practices of the companies and issuers they invest in.
- Shorting: The motivations behind shorting can vary, and the practice is seen as contentious by some, but if it’s done with the right spirit it can trigger major changes – and in a crisis recovery, change is much needed to ensure there will be no return to the situation(s) which caused damage in the first place.
- Innovation and data: Technology and human capital represent competitive advantages for many hedge funds, especially as most of the data they deal with on a daily basis is unstructured, requiring interpretation from people and systems to find beta or alpha. A period of recovery should provide hedge funds with a further incentive to apply an ESG lens to their innovation and expertise.
- Client demand: According to recent industry research[2], 34% of institutional investors believe ESG issues are material to investments, while another 44% think ESG-oriented investments provide opportunities for alpha. To be clear, this means there is significant client demand for hedge funds to take ESG factors into account within their strategies, and to develop new sustainable products.
- Leadership: Hedge funds can stand out in this time of crisis to really showcase their skills while also driving change to rebuild the economy.
Recipe for success
Every hedge fund strategy is unique and to ensure its success, a manager’s responsible investment approach should be tailored according to a firm’s culture, values, investment objectives and risk/return profile.
Nonetheless, there are some common features – policy, governance, investment process, and monitoring and reporting – that all hedge funds should look to include in their approach to ESG incorporation, as shown in our recently published guide.
ESG hedge fund due diligence – the new norm
Hedge fund managers cannot ignore that ESG criteria are playing an increasingly significant role in the manager selection process of institutional investors – represented by the steady growth of the PRI’s asset owner signatory base (from US$20.1 trillion in 2019 to US$23.5 trillion in 2020). ESG due diligence is becoming the norm, and a manager’s responsible investment practices form part of the criteria that asset owners evaluate when selecting managers. They want to see managers that are truly committed to the responsible investment practices they claim to use, where ESG factors are embedded across an organisation – in a firm’s culture and as well as their investment process.
Hedge funds must be net contributors to, not detractors from, a meaningful and sustainable recovery. With the eyes of regulators, asset owners and society at large focused on the industry, ignoring ESG issues will cost hedge funds far more than a few basis points. This is the time for hedge funds to be saints, not sinners.
This blog is written by PRI staff members and guest contributors. Our goal is to contribute to the broader debate around topical issues and to help showcase some of our research and other work that we undertake in support of our signatories.
Please note that although you can expect to find some posts here that broadly accord with the PRI’s official views, the blog authors write in their individual capacity and there is no “house view”. Nor do the views and opinions expressed on this blog constitute financial or other professional advice.
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