Doing good and maximising returns

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.

2. 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.