Hedge funds are pursuing ESG in unique ways

Hedge fund managers are including ESG considerations as both risk factors and alpha generators in their strategies — but not in ways allocators might expect.

Rather than focusing on proxy votes or engagement strategies, these money managers are looking at how to use classic hedge fund strategies to achieve positive ESG outcomes. These efforts are putting new pressure on companies with high emissions to collect and improve ESG data, and may also impact how allocators think about portfolio construction when it comes to ESG.

Environmental, social and governance investing has been top of mind for allocators and money managers for a number of years now, but the debate over how to do it and whether to do it seems to be entering a new phase. Both money managers and investors are putting a new focus on financial materiality in an effort to avoid greenwashing.

Much of the focus at the moment is on the “E” factors — specifically carbon emissions. Emissions have emerged as a metric that many asset managers and allocators are focusing on because they can be measured, sources said.

As more institutions focus on net-zero goals, measuring emissions has become a key factor of evaluation at the company and portfolio level. But any evaluation creates winners and losers. When it comes to emissions, fossil fuel companies emit more and end up having lower ESG scores, which can equate to them being labeled as higher-risk investments from an ESG perspective.

James Jampel, founder and co-CIO of $780 million Newton, Mass.-based energy market-neutral hedge fund firm HITE Hedge Asset Management LLC, argues that investors are in a difficult position when it comes to decarbonization because of the potential impact on the long-term financial performance of companies, which can raise fiduciary issues if pushing for change results in adverse financial results. HITE trades energy as a core part of its strategy and notes that these fiduciary concerns arise for any investor but especially those that are attempting to align portfolio construction to decarbonization or net-zero goals.

“Back before the pandemic, most of the energy companies were climate deniers. And investors became very frustrated with climate deniers. So really the only logical response then was to divest from these energy companies,” he said. “Then the pandemic hit, and energy companies performed very poorly in 2020. It looked like divestment was a winning strategy. Then, energy rebounded while at the same time the energy companies got smarter.”

For example, in 2021, after activist investment firm Engine No.1 ran a successful proxy campaign and board shakeup at Exxon Mobil Corp., Exxon and a number of other fossil fuel companies including ConocoPhillips joined the Oil & Gas Methane Partnership 2.0, an international consortium of high emitters that is focused on finding ways to improve the sustainability of legacy energy businesses.

According to Mr. Jampel, after these efforts got underway, “investors pivoted to engagement strategies with these companies so that they could reinvest. But that puts investors in a difficult place. They think they can change these companies from the inside and maybe they can or maybe they can’t but that remains to be seen.”

Mr. Jampel argues that if investors want to push for change inside these companies, they may have to argue against their interests.

“If the U.S. really wants to push decarbonization, the first step is a carbon tax, which other countries already have. We also need emissions limits. But if you’re an investor pushing for these things, you have to accept the value loss that can come from those and that gets tricky from a fiduciary standpoint,” he said.

Investors, he said, will have to weigh whether long-term investment performance will ultimately be supported despite any short-term value loss that would come from these kinds of policy shifts. He added that engagement may not be the best way to get there because investors have driven change before without running into the conflicting investing stances that seem to plague energy investing. “Investors didn’t ‘engage’ on tobacco,” he said. “They recognized the harm, and once they did, the regulation followed.”

The fluid nature of the energy transition is likely to make it difficult for allocators and policymakers to make straightforward determinations for a number of years. The war in Ukraine has already forced some European countries to momentarily change their energy policies.

For instance, the European Commission voted this summer to include nuclear energy and natural gas as environmentally sustainable investments in a new green taxonomy scheduled to take effect Jan. 1.

None of this comes as a surprise to Mark Carhart, chief investment officer and founding partner of the $1.9 billion New York-based systematic investment firm Kepos Capital LP. “We take the position that the transition is inevitable. But the timing of the transition is not yet known and policymakers are only just now beginning to realize that the social cost is going to be higher than they initially thought,” he said.

Mr. Carhart argues that decarbonization is still in the early stages and measuring emissions may not end up being a comprehensive metric for determining overall impact. Kepos takes a more opportunistic view of decarbonization and includes carbon-related factors, such as whether they are trading offsets to evaluate both legacy companies and assets, as well as to identify companies that are likely to lead the transition. That approach resonates with investors, he said.

“Investors we talk to are thinking of climate in terms of risks to the portfolio and how to hedge those risks. They also want to know what opportunities they can take part in as the transition happens. And so our focus on carbon transition gives us a view into both of those issues,” Mr. Carhart said.

Kepos currently trades in the carbon markets — where emitters like airlines, utilities and other companies can trade carbon credits and offsets. “One of the most interesting markets is the carbon market,” Mr. Carhart said. “Allowances are really the key area where there’s actually a tremendous amount of liquidity. There are interesting structural features, which generate a tailwind for performance.”

Cap and trade emissions trading systems are designed to reduce carbon dioxide emissions by placing a cap on total emissions and lowering the cap each year while allowing market participants to trade carbon, thereby setting the market price. There are a number of government-required and voluntary carbon markets that can be traded throughout the world, with more slated to come online over the next decade.

Index provider MSCI Inc. places the total value of the U.S. carbon market at approximately $270 billion.

While engagement is proving to be a little tricky within equities portfolios, on the fixed-income side it may be more straightforward.

DSC Meridian Capital, a New York-based opportunistic credit-focused hedge fund, has been able to make progress with companies on ESG through the high-yield market. The firm manages $800 million, half of which is in climate-focused strategies.

“High yield is only 3% of the fixed-income market, but these companies represent almost a third of U.S. emissions,” said Sheru Chowdhry, founder and CIO at DSC Meridian Capital. Many high-yield companies are in resource-intensive industries like energy, construction, light manufacturing and logistics.

“We spent a lot of time looking at how to approach ESG in an authentic way and with an approach that would lead to outperformance,” he said. “We settled on climate as a key driver, and what we have found is that when you show issuers that collecting ESG data and improving outcomes can improve their overall cost of capital, they do listen.”

Mr. Chowdhry noted that many high-yield issuers the firm evaluates are only in the early stages of collecting and reporting ESG data such as emissions or overall carbon footprint. But once they start, they may find new doors open in terms of financing as more investors are considering this data in their evaluation of securities. That means that companies can see a lower cost of capital, even if they aren’t yet making moves to improve ESG outcomes but are merely reporting impact.

“We are creditors, so that does give us a bit more credibility in the conversation,” added Paula Luff, director of ESG research and engagement at DSC Meridian Capital. “High-yield issuers are very sensitive to factors that can change their cost of capital. What we have found is that they are willing to have conversations and make change. That creates value for investors as well.”

Other, classic hedge fund strategies are emerging as a sort of quiet ESG. These strategies aren’t necessarily being deployed through a purely ESG lens, but the ways in which they can be used to manage risk in a portfolio can have significant ESG-positive benefits as well. In May, the Institutional Investors Group on Climate Change issued a paper designed to start a discussion around the use of derivatives and shorting in ESG strategies. The paper argues that both of these tools — commonly used in hedge fund strategies — can support net-zero commitments by separating financial risk management from net-zero alignment.

This theory of portfolio construction could help solve the fiduciary issues that come from engagement campaigns but it’s not definitive. The findings also create an opening for opportunistic strategies to be included more readily within ESG-oriented portfolios.

But some remain wary of finding more use cases for shorting and derivatives, which some consider to be controversial investment tools. MSCI published a report in April voicing skepticism of shorting and ESG. The investment research firm said without careful and fully transparent reporting, it will be challenging to fully understand the intent of long/short ESG portfolios and whether they are effectively meeting their stated goals.

Still, HITE’s Mr. Jampel noted that long-only ESG would limit the investment strategies available to allocators. Shorting could support investors’ ability to make change through investment, Mr. Jampel said, because it removes the conflict of interest involved in holding on to high emitters and hoping engagement will work. What’s more, it also provides a more authentic picture of the emissions in a portfolio. A short position would indicate that a company isn’t expected to materially improve its sustainability rather than holding on to an ESG laggard and hoping for the best.

“We contend that if you’re looking to measure the carbon intensity of a portfolio, shorts should be counted as a negative against other positive metrics you might have in your long book,” Mr. Jampel said.

Another classic strategy — merger arbitrage — is emerging as a way to improve ESG scores in a portfolio.

New York-based quantitative investment firm Versor Investments has analyzed the impact of mergers on ESG scores and come away with some notable findings.

“The standard approach is to invest with the goal of picking the highest ESG scores or finding significant improvements in ESG scores,” said Deepak Gurnani, founder and managing partner of Versor Investments, which had $3.4 billion in AUM as of June 30. “There is a lot of debate about whether that actually works or not. Our approach uses merger arbitrage. We have been able to show that merger arbitrage improved ESG scores in a statistically significant way. So we have been able to incorporate that in our quantitative and risk models as a consideration.”

Typically, Mr. Gurnani said, the target of a merger has a lower ESG score than the acquirer. Once the deal is complete and the company is absorbed, their ESG practices tend to improve as does the total score of the combined entity.

“We typically measure over a two-year period — one year before the announcement and one year after the completion,” he said. “A typical deal takes about four to five months. So within a 30-month period, we typically see that the improvement in scores is better than the sector average.”

That finding points to an ESG improvement many allocators may not even realize they have in their portfolio because merger arbitrage as a strategy doesn’t have to be done through an ESG-specific lens. Mr. Gurnani added that over time, merger arbitrage may take on more of an ESG tilt naturally because more companies are including discussion of ESG factors in their M&A plans.

Mr. Gurnani said this could be broadly beneficial for ESG because it can move the transition ahead without some of the issues and inertia embedded in other approaches. “From our perspective, the focus should be on strategies that improve the ESG scores rather than maintain the status quo,” he said.