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Hedge Funds and ESG: An Evolving Possibility

While hedge funds have grown to represent an important component of the alternative investment space, they have lagged the wider investment management industry when it comes to environmental, social, and governance (ESG) adoption and impact investing. Still, some investors and managers are tracking the emergence of new ESG hedge funds.

An Overview of Hedge Funds

The term “hedge fund” encompasses a wide range of strategies, many of which are considered niche. Operating with the driving goal of maximizing returns and minimizing risk, hedge funds are known for using sophisticated tools, including derivatives or leverage, to attempt to profit in up or down markets. They typically focus on equities, bonds, currency, or commodities.

Hedge funds are less regulated than standard investment vehicles, and they are accessible only to accredited investors, including certain high–net-worth individuals and institutions. That said, they are often held as a small underlying investment in the multi-asset funds marketed by conventional fund managers.

Besides striving for elevated alpha or active return, hedge funds are also characterized by their fee structure, with managers historically receiving 20% of annual profits and 2% of asset value, though observers have noted a decline in fees.

With their focus on “absolute returns,” hedge funds do not seem a natural fit for ESG and impact investing’s nuanced balance of financial and nonfinancial factors.

A Growing Opportunity for ESG Hedge Funds

Many view hedge funds as trailing in the uptake of ESG and impact investing, which have seen accelerated adoption across the mainstream fund management industry. A recent study by Context Capital Partners found that 51% of asset allocators to hedge funds had no ESG strategies in their alternatives portfolios, with 90% having less than a 10% allocation to ESG strategies. Meanwhile in the mainstream, 75% of asset owners and 62% of asset managers applied ESG principles to at least a quarter of their portfolios in 2019, according to a BNP Paribas study.

With their focus on “absolute returns,” hedge funds do not seem a natural fit for ESG and impact investing’s nuanced balance of financial and nonfinancial factors. While recent studies have suggested that ESG funds have matched and in some cases outperformed their conventional counterparts, certain hedge fund strategies may appear less suitable than others for ESG investing. For instance, commodities-focused hedge funds may find it difficult to stop investing in crude oil, still the world’s most widely traded commodity; many mutual funds operating basic ESG exclusion policies have long since ceased to hold fossil fuel investments due to their contribution to global warming. Meanwhile, ESG’s suitability for hedge funds using short-term trading strategies has also been questioned, though there is growing awareness that ESG can impact performance in the near term as well as in the longer term.

Still, some industry experts have charted a growing openness to ESG on the part of hedge funds. Reporting on the trend earlier this year, IR Magazine noted a variety of driving factors, from mounting client demand and firms’ maturing ESG capabilities to evidence of the materiality of sustainability issues and opportunities for alpha. In light of the demand for ESG hedge funds and their relatively short supply, Deloitte also highlighted a possible competitive advantage that might draw early adopters. “The value-add to managers is not only about interest in a specific fund,” explained Deloitte, “but also about how this creates opportunity to bring in new clients and deepen relationships with existing clients.”

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