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ESG investing for hedge funds: growing and advancing

Insight 26 April 2022

ESG investing for hedge funds: growing and advancing

ESG becomes hedge funds superpower.

A seismic shift has rocked the investment world lately, in the form of Environmental Social Governance, or ESG.

Hedge funds have certainly felt this shift as more fund managers work to incorporate ESG factors into their strategy. It’s easy to see why, when you consider just a handful of surveys that reflect the magnitude of ESG’s influence:

  • A 2021 Barclays survey showed that 22% of investors prioritize ESG when deciding what hedge funds to allocate to, which is twice as high as the same measure in 2020.
  • Flows for U.S. sustainable funds hit record levels in 2020, at $51 billion, according to Morningstar. That’s more than double the amount for 2019 and nearly 10 times the 2018 total.
  • A 2020 survey by Preqin revealed that 61% of institutional investors believe ESG will become even more integral to the finance industry in the next 36 months (while only 7% said ESG would become less integral).

Let’s examine some of the drivers behind ESG’s rapidly expanding role and how firms are responding to maintain a competitive edge.

We have observed three main factors fueling ESG’s increasingly significant role in hedge funds.

Broader societal shifts have placed privately-owned companies under greater scrutiny and created more pressure to “do good” by following ESG standards. This stems from widely reported global challenges such as climate change and income inequality. Increasingly, companies are compelled to be part of the solution, not the problem.

In addition, ESG used to face significant challenges because the environmental impacts of private companies were difficult to measure. Thanks to technological advances, a much higher level of transparency is now possible with the improved ability to collect information about CO2 emissions, water usage, and other environmental factors.

An even greater ESG obstacle was the belief that it represented a trade-off between fund performance and contributions to the well-being of society. This perception has changed because studies now show ESG can help hedge funds generate better returns, particularly over longer-term horizons. That’s the case with ESG compliant funds in the Eurekahedge database —they have outperformed their non-ESG peers in terms of annualized return over the last three-, five- and ten-year periods (10.59%, 10.03%, and 7.50%, respectively).

As ESG takes on a more influential role, leaders are adapting by developing a more structured, systematic approach to relevant initiatives. That’s certainly true for early adopters of ESG who followed their investors’ requests instead of grounding their efforts in a uniform set of requirements.

To generate strong investment returns as well as tangible benefits for society, leaders are creating a well-defined ESG strategy that creates real value and differentiation in the market. As the firm develops additional ESG initiatives, it’s important for senior management to express their support and reinforce ESG as a high priority. Service providers can also help contribute to a successful ESG strategy, including the development of a fund-level ESG management platform.

As firms implement ESG initiatives, it’s critical to demonstrate their effectiveness by developing ESG case studies. Firms must measure progress against key metrics and targets while tracking corresponding investment returns. This will give leaders a compelling story to share with the market. To develop case studies, firms need to adopt robust reporting programs that provide detailed information on ESG performance. As they seek ways to hone their ESG strategy, leaders can also participate in industry forums to help identify ESG-related opportunities and risks.

Investor needs vary widely, firms can’t rely on a single ESG playbook. Instead, they need to tailor their approach when incorporating ESG factors into an investment strategy.

Some large institutional investors with ESG investing criteria may want to bypass commingled funds. Instead, these investors will opt to allocate to separately managed accounts, allowing them to dictate the ESG parameters that apply. This provides transparency into the portfolio to ensure the fund adheres to the account’s ESG parameters. In addition, the manager can evaluate the efficacy of the investment from an ESG perspective. To accomplish both goals, leading hedge funds are leveraging ESG-specific reporting solutions that give managers and investors real-time insights.

Other ESG-sensitive investors might allocate to commingled funds. In this case, hedge funds must be prepared to adopt ESG policies and respond to due diligence inquiries. To make that possible, firms are partnering with service providers that can assist with research and provide insights that help reveal ESG risks and opportunities. In addition, firms are relying on those service providers to help them understand and populate the due diligence questionnaires, policies and procedures, and frameworks that LPs are seeking.

Excusal rights represent another avenue that some hedge funds use to meet LP ESG preferences. This can be a more straightforward approach than setting up a separate vehicle while allowing investors to avoid exposure to a certain industry or asset. When firms consider this approach, they’ll find the best fit occurs when the exclusion is only occasionally invested in and makes up a small proportion of assets.

ESG isn’t a trend that will fade out in a few years. We expect to see it play an increasingly prominent role in the analysis process for investors as they weigh the non-financial factors represented by ESG. As ESG becomes a more significant decision driver for investors, it’s shaping the decisions of fund leaders as well. They are creating more cohesive ESG strategies and tracking the results of initiatives with more detail and precision. As they work to meet investors’ needs, firms are also finding that additional effort is required to tailor ESG approaches for different LP preferences.

ESG is no longer a “nice-to-have”— it’s a necessity. With the right partners, hedge funds can make ESG their superpower by relying on experts and technological solutions that allow them to execute an effective strategy. That’s why choosing a service provider represents a crucial step in establishing a successful ESG program. When firms partner with a team that can support the ESG needs of the fund and its investors, they can generate strong investment returns, as well as tangible benefits for society.

How can Sanne help?

Sanne is a leading provider of alternative asset and corporate administration services. ESG services and expertise is delivered across hedge, private equity, private debt, capital markets, real assets, and corporate services. Our clients range from investing in ESG-compliant projects to launching Focus Funds or Impact Funds.

Sanne provides ESG reporting services and independent verification of ESG reporting and compliance, via our sophisticated cloud-based platform. We provide our clients and their investors with expert data analysis, governance, and education tools.

For additional information, or to discuss any of the topics highlighted above, please get in touch with Adrian directly.

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