Hedge funds and ESG: An investor’s perspective

While hedge funds have been slow to adopt sustainability, diversity, and inclusion best practices, managers are starting to catch up.

Some hedge fund managers have incorporated ESG metrics into their research processes and portfolios in the past, but over the past two years, there has been a rapid uptick in ESG efforts at hedge funds across all strategies.

Lilly Knight, co-head of investment management at K2 Advisors, said that as a group, hedge funds are “a little later to the game of ESG, but, true to form of hedge funds, once they learn about things, they quickly become adopters.

Lilly Knight (provided)

“We see this in our business,” she said. “Currently, of the 70 managers in our portfolio, 45 have formalized ESG policies in place. Five years ago, there were fewer than 10.”

One reason that hedge funds have been slow to implement ESG programs is simply that it can be difficult to assess many of the trading instruments used by hedge funds, such as derivatives, structured credit, and foreign exchange (FX).

Short selling also presents challenges, in terms of measuring impact, Knight said.

“Short selling is problematic because how do you determine if it is a net gain to short an offending security? And then, what about when you must cover a short position? It makes it hard for managers to figure out how to best apply ESG metrics to their trading strategies,” she added.

Another issue for hedge fund managers is simply finding someone with the expertise and ability to implement an ESG program and properly apply metrics.

As Knight explained, as an organization, K2 is a small group and many of the hedge funds in which the firm invests has small teams, and the small teams often don’t have an ESG expert.

“At K2, we’re fortunate to be a subsidiary of Franklin Templeton because as we worked on putting an ESG policy in place, we were able to go to Franklin Templeton to learn about best practices, what we should be thinking about, and what issues we should be addressing with our policy statement.”

“Most hedge funds don’t have that,” Knight continued. “They have to find a partner or hire someone who is dedicated to ESG. It’s been challenging for many hedge fund managers to find partners who can give good advice, especially for hedge funds that invest in assets that don’t fit into the ESG bucket, like FX.”

As more hedge funds look to develop and implement ESG programs, the best place to start is to think about what you can do from a firm level and what makes sense with your strategy, Knight advised.

For example, an activist hedge fund is going to have a vastly different approach to ESG than a traditional long/short equity manager, Knight noted.

“If you’re more passive in your investment style then you’re not going to have the engagement with companies that activist managers do,” Knight explained. “You can’t say you’re going to be actively engaging if that’s not in your process. So, you have to sit down and start with your investment policy statement to see what it is that you, as an organization, can do that is reasonable for a firm of your size, with your strategy.”

A firm’s ESG policy should lay down the firm’s ESG DNA, and its intentions, Knight advised. The ESG policy also should be tailored to your firm and investment strategy.

As it can be difficult to apply ESG best practices to an investment strategy, Knight said firms that could not apply ESG at the fund level could still adopt practices on a firm level.

“Hiding behind the excuse that your strategy doesn’t fit into ESG doesn’t work because even if you can’t do it in your fund, your organization can still apply ESG and you can implement best practices from an employment and business perspective,” Knight said.

“It’s a problem for me when a manager says they don’t do ESG because their strategy doesn’t fit into it or because no investors are asking for it. That gives me pause. We know investors are speaking to hedge fund managers about ESG, and they’re doing so more frequently,” Knight added.

While ESG has become more widely adopted in the hedge fund space in the past two years, and more frequently in the past 12 months, she expects to see more hedge funds dedicated to ESG in the future.

“Hedge funds are known for being innovators in all aspects of their businesses,” Knight said. “They must innovate to stay ahead to generate outsized returns. I think this will apply in ESG. And once hedge fund managers have figured out a way to address some of the bigger issues in adopting ESG, once that innovative nature of hedge fund managers takes on this challenge, you’ll see more widespread adoption across the industry.”

Jennifer Banzaca

Jennifer Banzaca has been a reporter and editor covering the hedge fund industry for 14 years, most recently focusing on legal and compliance issues.
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