ESG is one of the fastest-growing categories of asset management. In 2019, investors poured $20.6 billion into funds that incorporate environmental, social and governance factors — a 400% increase over ESG inflows in 2018, boosting the total to $137.3 billion in assets in the U.S., according to Morningstar.
While traditional active managers and passive providers, which account for $20.7 trillion in assets in the U.S., are mobilizing to meet the growing demand for ESG, one category of active manager seems to have its head in the sand — hedge funds. Only 37% of hedge fund managers — vs. double that number for their alternative asset manager peers — believe ESG will become more important over the next five years, according to a Preqin survey.
This ho-hum response from hedge funds is also ironic: The Patagonia vest-clad innovators who spawned a $3 trillion industry are behind the curve on possibly the biggest shake-up to asset management since, well, themselves.
It's time for hedge funds to up their ESG game or they risk losing money and losing assets.
First of all, ESG is risk management. For example, 90% of bankruptcies in the S&P 500 from 2005 to 2015 occurred in companies with poor ESG scores in the preceding five years. Another analysis shows ESG to be a better predictor of future earnings risk than standard metrics such as leverage and profitability. And a growing body of research corroborates positive risk management impacts from ESG with no negative impact on performance, often the opposite. Traditional active managers are becoming much more sophisticated in their assessments of ESG-related risks; hedge fund managers would be wise to keep up or they could get caught on the wrong side of a trade.
Secondly, clients are demanding ESG. Of hedge fund clients, 65% believe ESG will be more important over the next five years and 42% would consider redeeming a current investment if it did not meet their ESG requirements, according to Preqin. Almost half of high-net-worth individuals, a key hedge fund investor base, either own or are interested to add ESG investments, and that percentage rises to more than 75% for millennials, a key future investor base. Institutional investors increasingly view ESG as a risk management tool, and many pension funds have actually evolved their interpretation of fiduciary duty to encompass ESG considerations.
Hedge fund managers are already noting a corresponding uptick in client requests regarding ESG policies. This is a wake-up call and hedge fund managers should stop hitting the snooze button. There is an immediate opportunity to use their nimble structures and innovative cultures to offer ESG to clients in ways that passive and traditional active managers cannot.
The number of passive ESG options is growing rapidly, but passive investments have limited (if any) ability to employ proprietary research, use human judgment, engage with management, take short positions or invest in less-liquid assets, all of which enhance the potential to successfully incorporate ESG in an investment strategy.
Active managers, which have been struggling to stem outflows to passive options, have found new purpose with ESG. In many cases, ESG is a natural fit with existing investment processes and products that are built on proprietary research and engagement with company management teams. But the quality is uneven and some offerings may not impactful or meaningful enough for more sophisticated investors.
More agile and less-regulated managers, such as hedge funds, have the advantage of being able to invest in a wider range of assets (less liquid or private) and strategies that can generate the performance these clients are seeking with the ESG considerations they are now demanding. The field is wide open for new hedge fund strategies that differentiate themselves precisely by daring to lead with ESG as a starting point.
For managers looking to integrate ESG into existing hedge funds, clearly some strategies will lend themselves to an ESG lens more readily than others; a strategy with a longer investment time horizon, for example, can more easily integrate ESG. It is also true that sustainability data can be inconsistent and substandard. There is no "plug-and-play" solution and ESG integration requires some outside-the-box thinking. But to completely ignore ESG is to ignore the changing investment landscape and evolving client expectations.
Even ETF providers — which by definition seek to be passive — are facing up to the challenge. The tremendous growth in ETF assets worldwide to a record $6.3 trillion at the end of 2019 means that large passive investment providers are awkwardly finding themselves as the biggest shareholders in many companies. Keenly aware of this risk, as well as changing investor attitudes—85% of individual investors now indicate interest in ESG — passive investment providers are realizing they have a responsibility to act.
Whatever the level of ESG integration, be authentic. Greenwashing is the new closet indexing. It won't help risk management, will have uneven effects on performance and won't prevent asset outflows or attract new inflows from clients that are serious about ESG.
The 2020s look set to be the decade where ESG investing has an impact. All asset classes have been nascent at one stage or another and ESG is no different. Hedge funds need to bring back the innovative spirit from the 1990s to take the industry from laggard to leader.
The smart money should be on ESG.
Sarah Berner Donahue is managing director of Aristeia Capital LLC, New York, and founder of One House, a platform committed to supporting female founders and impact-positive organizations. This content represents the views of the authors. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.
