ESG may be the global rage among institutional investors, but hedge fund firms have been the slowest among alternative asset managers to integrate the principles into long/short investment strategies.
The dearth of ESG-compliant hedge funds is not the result of investor disinterest. Rather, investment consultants said asset owner demand for ESG integration across all strategies is at its highest level ever.
A survey of institutional investors by industry researcher Preqin found that 29% have an ESG policy for their hedge fund portfolio and another 20% of respondents said they will add such a policy this year. The balance of asset owners surveyed don't have a hedge fund ESG policy.
By contrast, hedge fund managers have been significantly slower to integrate environmental, social and governance principles into their investment process, Preqin data showed. Some 65% of hedge fund managers surveyed don't have an ESG policy, while only 20% of hedge funds Preqin contacted have adopted an ESG policy and 15% said they will implement such a policy in 2019.
Leading the charge into ESG-fueled hedge funds is the $233.9 billion California State Teachers' Retirement System, West Sacramento, which announced in February it would make a $250 million anchor investment in startup activist hedge fund Impactive Capital LP, New York, which is explicitly incorporating ESG principles into its whole investment process.
But even as traditional, private equity, real estate, private credit and infrastructure managers are building consideration of ESG factors into their investment processes, few startup and long-tenured hedge fund managers have followed suit.
"Investor interest in ESG is very high," said Joseph Larucci, a partner at alternative investment consultant Aksia LLC, New York.
"It's very topical right now in the U.S. CIOs are being asked about integrating ESG into the portfolio by boards," including for hedge funds, Mr. Larucci said.
Specialist hedge fund consultants said they haven't seen a groundswell of interest from hedge funds to incorporate environmental and social principles into their investment process.
One reason for the low level of ESG adoption among hedge fund managers is that it's impossible to apply ESG factors to hedge fund strategies — namely systematic trend-following and discretionary global macro — because these approaches are top-down and dependent on market conditions, said Christopher Walvoord, partner and global head of hedge fund research at Aon Hewitt Investment Consulting Inc., Chicago.
He said more fundamentally oriented hedge fund strategies, such as equity long/short, relative value, event-driven and convertible arbitrage, offer more opportunity to implement ESG principles within the investment process.
Another impediment to full adoption of ESG principles is the "hesitancy some hedge fund managers have about saying out loud that they are investing using ESG factors because they think it will seem too much like they're doing socially responsible investing," which they think may have negative connotations to investors, said Reino G. Ecklord Jr., research consultant-hedge funds, who is based in the Chicago office of investment consultant NEPC LLC.
"Some hedge fund managers already have incorporated ESG into their investment process and the conversation about what they are investing in is evolving to become more explicit about ESG," Mr. Ecklord said.
To advance the dialogue about the application of ESG factors in the hedge fund investment process, NEPC is planning a webinar later this year to help managers better articulate their approaches, Mr. Ecklord said.
NEPC and other consultants including Aksia, Aon Hewitt and Verus Advisory Inc. are creating ESG due diligence, measurement and rating systems for all investment strategies, including hedge funds, to augment traditional manager evaluation.
"Evaluation of money managers' ESG implementation will become the industry standard," Mr. Ecklord predicted.
Eileen Neill, senior consultant at El Segundo, Calif.-based Verus Advisory said: "Verus has spent the last couple of years getting ready for ESG. We want to have an ESG evaluation option for every asset class we recommend to our investment clients, including hedge funds."
As part of manager due diligence, Aksia has been asking hedge fund managers about ESG implementation into their investment process and has come across some "greenwashing," said Timothy J. Dooley, Aksia, investment due diligence analyst.
"You have to have an extra level of skepticism about who is really incorporating ESG and aligning their interest with that of the investor to meet the client's goals," Mr. Dooley said, noting that some hedge fund managers are vague in their descriptions of their ESG integration practices.
One area where some hedge managers have a leg up on others is within the industry's cadre of activist hedge fund managers, industry observers said.
These managers have focused on the governance part of ESG for decades, in some cases through engagement campaigns with companies they're invested in to improve financial performance.
"Activist hedge funds get a hall pass when it comes to ESG because governance has always been part of their investment process. This part is easy," said Aon Hewitt's Mr. Walvoord.
"When it comes to environmental and social issues, in our observation, we've seen limited adoption of these principles by hedge funds. The modifications these firms are making generally aren't enough to satisfy a staunch environmentalist," Mr. Walvoord added.
Two examples of activist firms that have embraced ESG are Trian Fund Management LP, New York, and ValueAct Capital Management LP, San Francisco.
Both firms have adopted explicit ESG practices and principles and incorporate them throughout their investment processes, consultants said.
Trian, for example, espoused on its website that it "believes that ESG issues can have an impact in a company's culture and long-term performance and that companies can implement appropriate ESG initiatives that increase their sales and earnings. We also believe that the consideration of ESG factors enhances our overall investment process."
Trian managed $8.9 billion in discretionary assets as of Dec. 31 and ValueAct managed $13.9 billion as of Feb. 28 in regulatory assets, according to each firm's most recent ADV filing with the Securities and Exchange Commission.
Christian Alejandro Asmar and Lauren Taylor Wolfe, co-founders and managing partners of Impactive Capital, founded their firm in March after leaving activist hedge fund manager Blue Harbor Group LP, Greenwich, Conn., in 2017.
They brought with them a focus on long-term investment and a strong commitment to applying ESG principles to the investment process, said Mr. Asmar.
"We're building a concentrated book of high-quality companies and will hold them for a long time. We have to sell ESG not only to asset owners who invest with us, but also to the companies we invest in. We're incorporating ESG in a way that fundamentally improves the businesses of the companies in our portfolio," he said.
CalSTRS is Impactive Capital's first investor, but Mr. Asmar said the firm is seeing demand for ESG activism from other institutional investors.
Clifton S. Robbins, CEO and portfolio manager at Blue Harbor Group, said the firm has practiced responsible investing since its launch is 2004, but began to manage the firm's $2.2 billion in long-only and long/short equity strategies using ESG principles in 2016.
"ESG is fundamental to everything we do now," Mr. Robbins said, adding that the industry's nascent move to incorporate ESG is "very exciting. It's been talked about for years but it's really happening. It's a way to both reduce risk and add alpha returns."
He predicted that within two to four years, all publicly traded companies will have buy/sell ratings based on ESG.
