ESG Considerations for Equity – Hedge Fund Strategies

One of the most significant events in sustainable finance came in 2020 when Larry Fink, the CEO of BlackRock, the largest asset manager in the world, called for a fundamental reshaping of finance. The reshaping that Larry had in mind was to put climate change and sustainability issues at the center of risk assessment and capital allocation. The letter is a clear warning to company CEOs: climate and sustainability risk is investment risk. As other investors come to this same realization, the implications for asset values and the reallocation of capital could be profound. Changes to capital markets could come much more quickly than the physical impacts for climate change itself given the propensity of capital markets to discount future risk today.

Considering climate and sustainability risk in your company’s capital allocation process is no longer optional. In fact, BlackRock has even gone as far as to state that they will vote against management and board directors of companies that are not sufficiently incorporating sustainability practices into business plans. BlackRock has stated that they expect that sustainability integration will ultimately result in lower investment risk and better market returns. In short, sustainability is the new standard for investing.

Given that companies will face increasing shareholder pressure to incorporate sustainability into capital allocation, enterprise risk management, and standard operating procedures, it is essential to understand the underlying investment drivers for asset managers and how they might consider environmental, social, and governance (ESG) or sustainability risk factors. Clearly, climate-related risk is the most material ESG risk for many industries and sectors, but health and safety, labor management, anti-corruption, and toxic environmental releases are also key issues that must not be overlooked ^[1].

In this thought-leadership series, we look to put you in the shoes of the asset manager. How are investment decisions made? What are the unique implications for various asset-classes? How do asset managers consider investment risk? How is traditional asset management balanced with ESG considerations? These are some of the questions that we hope to tackle. Our goal is to help companies better understand the asset manager process and prepare for the shifting expectations around sustainability integration and disclosure. Those companies that can navigate this fundamental reshaping in finance will be best positioned for growth as the economy transitions to a more sustainable, lower-carbon future.

Introduction

In this thought-leadership piece, we provide the reader with an overview of hedge fund strategies and the implications for ESG investing. When compared to traditional investments, hedge funds typically have lower legal and regulatory constraints, more flexible mandates that incorporate shorts and derivatives, and a larger investment universe. Hedges are also characterized by their more aggressive investment styles that may use high leverage and seek exposure to credit, volatility, and liquidity premiums. To gain access to hedge funds, investors may need to commit to a lock-up period and pay relatively high management fees.

Hedge funds can be classified based on the investment instruments used, the trading philosophy of the investment manager, and the types of risk they assume. The general hedge fund classifications are equity-related, event driven, relative value, opportunistic, specialist, and multi-manager. We will detail each of these classifications in this newsletter outlining their characteristics and the role that they play in a balanced investment portfolio. We then shift from our overview of hedge fund classifications to the ESG considerations associated with investing in hedge funds.

Equity-related Hedge Funds

There are three major categories of equity-related hedge fund strategies. The first is the long/short strategy which typically involves a 70-90% long position and a 20-50% short position. The long/short strategy takes advantage of the diverse opportunities globally to create alpha through skillful stock picking with a goal to achieve long-only returns with 50% less volatility. A second set of equity-related hedge fund strategies include the dedicate short strategy (which is 60-120% short) and the short-biased strategy (which is 30-60% short). These short strategies typically have negative correlation with traditional assets and returns that are low (and more volatile) than a long/short strategy (given the negative exposure to the market). Short strategies usually focus on shorting individual stocks rather than the entire index. Short strategies use little or no leverage. The third set of equity-related hedge fund strategies are equity market neutral strategies. Equity market neutral strategies profit from short-term mispricing between securities. The strategies have low beta risk, are attractive in weak markets, and use higher leverage to get meaningful returns. Opportunities are identified quantitatively. The strategy can offer modest returns, but more importantly, can increase diversification and reduce portfolio risk.

Event-driven Hedge Funds

Merger arbitrage is an event driven hedge fund strategy that involves simultaneously buying and selling stocks of two merging companies to create riskless profit. The returns are insurance-like and have a high Sharpe ratio with the payoff resembling a riskless bond and short put option. The strategy has high liquidity but significant left tail risk and can result in negative returns if the merger fails unexpectedly. The investment manager can use high leverage to generate meaningfully higher returns. Distress security investing is a second event driven hedge fund strategy. The strategy focuses on firms in financial distress that have low liquidity. The investor is typically long biased and will use low to moderate leverage. Distressed companies will move to either liquidation or reorganization. In liquidation, assets are sold off and security holders are paid sequentially based on the priority of their claims—from senior secured debt, junior secured debt, unsecured debt, convertible debt, preferred stock, and finally common stock. In reorganization, the terms for claims in the capital structure are revised and renegotiated. Through this reorganization, debt holders may have the option to extend the maturity of debt or get equity in exchange for debt.

Relative Value Hedge Funds

Relative value hedge fund strategies often have high exposure to credit and liquidity risks. One type of relative value hedge fund strategy is fixed-income arbitrage. This strategy seeks to profit from mispricing of bond valuation differences that can result from credit quality, liquidity, and volatility. Returns are a function of the correlation between securities and the yield spread pick-up available. Investment managers that implement this strategy must navigate the high number and diversity of debt securities. The strategy is usually highly levered and most commonly includes yield curve trades and carry trades.

A second type of relative value hedge fund strategy is convertible arbitrage where the investment manager will buy the relatively undervalued convertible bond and take a short position in the relatively overvalued underlying stock. In this way, the manager seeks to extract underpriced implied volatility from a convertible bond. To manage market risk exposure, the manager will delta hedge and gamma trade short equity against the convertible positions. This strategy is best when there is high convertible issuance, adequate liquidity, and moderate volatility in the market. The strategy is subject to left tail risk if there is high market stress, which could lead to liquidity issues and a high cost to borrow equity for short selling. Generally, the investment manager will be 300% long and 200% short in order to earn meaningful returns. When credit spreads widen or narrow, there will be a mismatch in the values of the stock and convertible bond positions that the convertible manager may or may not have attempted to hedge.

Opportunistic Hedge Funds

Opportunistic hedge fund strategies rely on high liquidity securities, use high leverage, and take a top-down approach. A global macro opportunistic strategy uses a wide range of asset classes and instruments and seeks to exploit trends using a discretionary or systematic approach. This gives the investment manager diversification during periods of market stress. A managed futures hedge fund strategy has similar aims as a global macro strategy, but uses futures and option futures on stock, fixed income, commodities, and currencies. The strategy exhibits right tail skew during market turmoil. The manager will typically use a systematic approach, use high leverage, and rely on highly liquid securities. A managed futures strategy will deliver similar diversification during stress periods as a global macro strategy, but with more heterogeneous outcomes. As part of this strategy, managers will consider time series momentum (managers go long assets that are rising in price and go short assets that are falling in price) and cross sectional momentum (going long those that are rising in price the most and by shorting those that are falling the most). Cross sectional momentum strategies typically result in a net zero market exposure during normal periods, while the time series momentum strategy can be net long or net short depending on positive and negative absolute returns.

Specialist Hedge Funds

Specialist strategies involve investment in niche markets and offer returns that are uncorrelated with the market. Volatility markets are one such niche market. Volatility traders strive to capture relative timing and strike pricing opportunities due to changes in the term structure of volatility. Traders will seek to capture volatility smile and skew by using spreads (bull, bear, and calendar) and straddles. Over-the-counter options, VIX futures, volatility swaps, and variance swaps are also used. Another specialist strategy called life settlements, involves purchasing pools of life insurance contracts whereby the hedge fund becomes the beneficiary. The strategy looks for policies with a low surrender value, low ongoing premium payments, and a high probability that the insured will die soon.

Multi-manager Hedge Funds

A multi-manager hedge fund approach can use any combination of the previously mentioned strategies. The key benefit of multi-manager approaches are strategy diversification and low volatility of returns. A fund of funds multi-manager approach offers a broad strategy mix, but has the drawback of low transparency, high exposure to netting risk, and low tactical speed. A multi-strategy fund addresses many of these drawbacks and offers better fee structure and faster tactical asset allocation. However, because a multi-strategy fund relies on a single fund with a combination of strategies, it has higher operational risk and lower diversification.

Implications for ESG Investing

Having covered some of the foundational concepts of hedge fund strategies, we now turn our attention to ESG and sustainable investment considerations. ESG investments may have lower volatility during market turbulence, but is the same true of hedge fund investments? To assess portfolio volatility, we can use a conditional linear factor model to understand hedge funds risk exposure in normal and stress periods. This assessment incorporates risk across four axioms: equity risk, credit risk, currency risk, and volatility risk. Empirical data shows that incorporating an allocation to a hedge funds in a traditional investment portfolio can result in lower portfolio volatility, lower maximum drawdowns, and higher Sharpe and Sortino ratios. These benefits can be achieved by shifting the conventional 60% equity and 40% fixed income investment portfolio to include a 20% allocation to hedge funds.

While the risk and return benefits of hedge funds are well established, how can a hedge fund strategy incorporate ESG factors? Some have quipped that an ESG hedge fund is an oxymoron. However, that view is changing. While hedge funds may be bias to the shorter term and can be frequent traders, the strategy may be predicated on a longer-term view or thesis ^[2]. Hedge funds can take ESG beyond long-only equity management to diversifying strategies and asset classes that include, commodities, global macro, long-short credit, relative value, systematic trading, and activist investing. Specialist hedge funds may also help solve the ESG data quality issue by using analysis techniques such as natural language processing. ESG investing strategies that have a long/short mandate have the opportunity to go long virtue stocks (e.g. a company drilling freshwater wells in Africa) and short sin stock (e.g. weapons, alcohol, tobacco).

The UN Principles for Responsible Investment offers a technical guide on how ESG might be incorporated into hedge funds ^[3]. The heterogeneous nature of hedge funds means there are important differences for how a fund might incorporate, develop, and implement an ESG investment policy. The guide offers a responsible investment framework that includes four modules:

1. policy;
2. governance;
3. investment process; and
4. monitoring and reporting.

The ESG policy can be formulated at the investment manager level and the portfolio level. Governance is a core component of the framework and includes a written ESG policy, processes, practices, and reporting guidelines that could include relevant ESG metrics (e.g. gender-diversity at the board of director level). The investment process includes issue such as proxy voting that overlap between long-only strategies and hedge fund strategies. Some ESG asset owners are concerned about the impact short selling has on shareholder rights, exercising stewardship, and its potential impact on share prices, so this practice is still very much contentious from an ESG perspective. The final section of the framework focuses on the reporting of activities and reporting of progress made towards implementing the Principles for Responsible Investment. This includes reporting on how ESG is integrated, disclosure of active ownership, and reporting in a way that is timely, consistent, and recurring. This type of reporting gives company managers significant insight into the ESG investment process.

Conclusion

As we look to put you in the shoes of the asset manager, our hope is you will gain a deeper understanding of ESG integration and the investment management process. The companies that understand the asset manager’s decision-making rationale for incorporating sustainability and climate-related risk are likely to be the most responsive to changing investor requirements and trends. As global efforts are made to transition the economy to a more sustainable, lower-carbon future, we expect that investor demands for sustainability performance and disclosure are set for significant growth. Companies should begin to prepare today in order to meet investor expectations in the future. This will require having the right infrastructure for collecting sustainability-related data, understanding performance, reporting on key indicators, and setting targets to improve. Ultimately, companies that can master this core competency will gain more shareholder interest and will be poised for superior performance. Now is the time to seize the opportunity in the shift to sustainable investment.

References

1. https://www.msci.com/www/blog-posts/which-esg-issues-mattered-most/01934601065
2. https://www.ipe.com/esg-hedge-funds-a-contradiction-in-terms/10027606.article
3. https://www.unpri.org/hedge-funds/technical-guide-esg-incorporation-in-hedge-funds/5729.article

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