ESG hedge funds: playing both sides

Playing Both Sides

The proliferation and evolution of hedge funds has been spectacular over the last three decades. From a relatively niche investment option in the early 90’s for sophisticated investors, hedge funds are now part of the mainstream. For better or for worse.

An allocation to hedge funds can make sense if the underlying funds are well understood and the allocation is consistent with the objectives of the overall portfolio. However, given the complexity of hedge funds and their higher fees, advisors must provide sufficient education on the mechanics of these funds in order to manage the expectations of clients.

ESG Hedge Funds

Hedge funds have shown themselves to be extremely nimble, successfully seeking out new sectors and markets to infiltrate. The momentum behind ESG investing has not gone unnoticed and we are now seeing more hedge funds enter the ESG space, proposing their own twist on how ESG can be used to enhance returns.

Recently, an investment firm announced that they will be launching a new long-short ESG fund as their hedge fund unit ‘is interested in bets based on environmental factors’. There is a lot to be considered by an investment committee and whether such a fund aligns with their responsible investment policy.

Consider for a moment a potential conundrum that could play out.

Assume company A is a standout sustainable company that ranks highly on their environmental performance. As a result, the stock price has risen in value due to investor preference for companies who rank highly on their environmental performance. The Long-Short ESG fund looks at the stock price and even though it ranks highly on environmental performance, they judge the stock price to be overvalued based on the irrational exuberance of green investors. 

Now take company B. Their environmental performance has been horrendous, and the stock has suffered a sharp decline after weeks of negative news flow regarding protests related to the behaviour of their subsidiary companies in Latin America. The Long-Short ESG fund looks at the stock and while the company has shown complete neglect of basic environmental rights, causing many big-name investors to sell, the long-short manager considers the stock cheap on a valuation basis. 

Without any baseline standard in terms of an acceptable level of environmental performance of the companies they invest in, the long-short ESG fund may end up going long (buying the shares) the environmentally destructive company and going short (borrowing the shares to sell them) the company the environmentally conscious company.

It runs counterintuitive to what the average investor might expect of an ESG fund. An important factor will be whether the hedge fund takes a fundamental position on the environmental performance of companies. Otherwise, the use of ESG is merely an indicator to determine whether a stock is overbought or oversold based on the preferences of a growing cohort of responsible investors.  

Such a fund using ESG as a technical indicator is indifferent to the impact of a company on the environment. Hence, capital allocators need to look beyond the ESG label when it comes to fund selection.

End

Vincent McCarthy, CFA

Founder, ESG Ireland

(Article featured in The ESG Factor newsletter. To subscribe, e-mail: Insights@ESG.ie)

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