One of the biggest trends that has taken hold of the financial industry has been environmental, social and governance (ESG) considerations. However, hedge funds are widely seen as being among the slowest groups to adopt ESG factors in selecting investments.
A recent paper from Peltz International highlighted fund managers’ progress on ESG issues and the outlook for ESG going forward.
Why are hedge funds slower to adopt ESG?
According to Peltz, ESG investments now represent about one-third of all assets managed by professionals, but hedge funds have lagged large traditional asset managers in adoption. Eurekahedge tracks 65 ESG-focused hedge funds that account for only about 3% of all hedge funds.
According to Peltz, only 7% of hedge funds feature “high” ESG integration, the lowest of the 13 different manager types. Additionally, this segment of the industry had the second-highest percentage of managers with low or no ESG integration, at 64%.
The researchers suggested several reasons hedge funds appear to lag behind other asset manager types in ESG adoption. For example, they noted that hedge funds often have shorter holding periods in their investments, while ESG investments tend to have longer horizons.
Additionally, many fund managers don’t want to restrict their investment universe. Meanwhile, others sell stocks short as a method of activism, although short-selling is not seen as an ESG strategy despite its goal of pushing for change at companies.
The lack of regulations around ESG is also a concern for many hedge fund managers.
Concerns about ESG
Interestingly, demand for ESG investment vehicles is cooling following three straight years of growth. According to Morningstar, the first quarter saw $97 billion in asset flows for ESG vehicles, a 36% decline from the previous quarter that marked the largest slowdown in three years. Stock investors redeemed $2 billion from US ETF ESG funds in May—the largest recorded monthly redemption for the strategy.
Peltz researchers also highlighted several developments that have presented new obstacles for ESG, including the growing backlash against it, the bursting of the tech bubble, and Russia’s invasion of Ukraine. They noted that the ESG market is maturing, which has brought increased scrutiny.
For example, a whistleblower accused Deutsche Bank of greenwashing, while a former BlackRock
ESG funds find support in stock selection
However, the news for ESG funds isn’t all bad. This year as the global stock markets have tanked, ESG funds have also fallen, although to a much lesser extent. ESG-focused funds often are heavily allocated to technology due to the sector’s lower carbon footprints and diversity and human rights policies.
As a result, many ESG funds found support when Big Tech rallied during the pandemic. In fact, Microsoft
Interestingly, oil and gas companies still make up a minuscule part of ESG portfolios, which has also supported ESG funds due to their outperformance this year.
Priorities shift after Russia’s invasion of Ukraine
Russia’s invasion of Ukraine further highlights the ESG market’s shifting priorities. Suddenly, energy security, food security, and poverty reduction took up positions alongside climate change as critical issues supported by ESG funds.
Before the invasion, ESG-focused investors were underweight oil and gas companies. Additionally, while European asset managers have led the way in ESG adoption due in part to regulations by European governments, some of those governments have reneged on their environmental goals. The continent’s energy crisis has led officials to turn to fossil fuels to reduce its dependence on Russian energy.
“Qualifying” oil and gas companies now make up a larger slice of some ESG funds’ holdings. For example, oil giant ExxonMobil
Defense companies have also long been avoided in ESG portfolios, but several funds added the sector to their holdings due to the war and tensions in Europe. In fact, Peltz researchers found that some industry experts believe the defense sector should now be categorized as sustainable.
They also emphasized that all these changes occurred because ESG-focused asset managers and investors changed their priorities due to certain developments this year.
How regulations could boost ESG
In their outlook of what to expect from the ESG market in the coming years, the analysts at Peltz they expect regulations to speed up the formalization process and procedures for ESG investing. For example, the Securities and Exchange Commission asks asset managers to categorize themselves as ESG in their Form ADV if they are considering ESG factors or have dedicated ESG funds.
Observers have seen how ESG has become a prominent issue for institutional investors as they do their due diligence on potential investments. Thus, it will be challenging for managers to claim they don’t consider ESG factors at all unless avoiding them is specifically part of their strategies.
Of course, increased ESG regulations will push more managers to implement policies on the matter. Managers who have informally integrated ESG factors in the past will face increased scrutiny by the SEC and in investor due diligence, depending on how they have categorized their funds.
Potential obstacles to ESG regulations include legal challenges and failures to comply. Of course, Europe has long been considered the standard on ESG adoption, especially in terms of regulations. However, Bloomberg reported earlier this year that European financial advisers were failing to comply with some rules requiring them to discuss ESG preferences with their retail clients.
Of course, differences in ESG implementation by region will also exist. For example, institutional investors in the U.S. may be less willing to sacrifice returns for ESG-related outcomes.
Another critical issue right now is the lack of regulations for providers of ESG ratings and data. Reporting of ESG metrics has not been standardized, meaning that ratings are based on “subjective judgments and incomplete data,” according to Peltz researchers.
Due to the lack of standardizations, rating agencies often disagree wildly in their ESG assessments. Additionally, investors can’t determine how ethical or responsible each fund is compared to others, and managers face challenges in reporting their data to regulators.
A recent study by the Sloan School of Management at MIT and the London Business School points to the same issue. The study found significant gaps in ESG measurements, persistent problems with data quality, and issues assessing company ratings versus their financial performance.
The researchers found a correlation of 0.92 between credit agency ratings. According to them, the confusion is caused by what is being measured rather than how the various factors are weighted.
They report that 56% of the confusion is caused by a significant divergence in how various ESG factors like sustainability or inclusion are measured. Differences in scope accounted for 38% of the differences among rating agencies, while variances in weighting methodology accounted for just 6% of the divergence.
Lack of transparency
Researchers also found a lack of transparency in how agencies calculate their final ratings. Many agencies name their indicators and state the weights they used, but they don’t explain how they created those indicators or what data they used.
Another issue is a lack of publicly available information. ESG firms typically use industry averages, giving poor performers “a free ride.” Additionally, some companies perform well on the “E” part of ESG but poorly on the “G” and “S.”
It’s suggested that Tesla’s removal from the S&P 500’s ESG Index earlier this year was due to its weak ratings in governance and social issues. Two negative factors impacting Tesla’s score were a decline in its lack of low carbon strategy and codes of business conduct.
Other issues mentioned claims of racial discrimination at the automaker and poor working conditions at its factory in Fremont, Calif. Additionally, there were mentions of Tesla’s handling of the National Highway Safety Administration’s investigation following multiple deaths and injuries in connection with its Autopilot system.
Companies are rated against their industry peers for an apples-to-apples comparison. In a statement, the S&P Dow Jones Indices clarified that Tesla’s ESG Score remained stable compared to last year, but its industry peers had improved, pushing it down the ranks.
Further, ESG criteria are also biased. For example, some rating agencies might consider a company’s direct greenhouse gas emissions but not their Scope 3 emissions or emissions from the use of their products. As a result, Tesla might get less credit for its environmental prowess, while ExxonMobil might not be penalized as much as it would otherwise.
Greenwashing and other themes
Many investors and market observers have also been concerned about greenwashing. However, regulators around the globe are cracking down on managers that overstate their ESG credentials, citing several specific examples.
They also reported that pressure from institutional investors is a primary driver of ESG adoption among fund managers. In fact, 60% of respondents in a study conducted by bfinance said ESG issues played a significant role in their manager selection, compared to 41% in 2018.
The study also observed an increased focus on data and measurement issues recently. Further, the firm pointed out potential opportunities for activist managers with solid internal ESG policies targeting underperforming companies lagging on ESG policies.
The researchers also highlighted the increasing focus on the “S” part of ESG due to the recent events highlighted above. Historically, most strategies have been focused on the environment rather than social issues.
Additionally, until now, activist funds have focused primarily on shareholder value and the “G” part of the equation. However, now they are looking harder at environmental and social issues.
Michelle Jones contributed to this report.