ESG considerations in liquid alternative strategies

Sustainable investment is usually associated with a long-term, buy and hold approach.

But hedge funds are arguably at least as well-placed as their long-only peers in using environmental, social and governance (ESG) factors to construct portfolios. Their ability to go long and short can be a considerable advantage. Not least when it comes to holding companies to account for poor governance.  

Indeed, many of the corporate scandals of the past few decades might not have come to light had it not been for hedge funds. 

It was a hedge fund that first spotted the problems at energy giant Enron, pursued suspected fraud at fintech darling Wirecard, and unearthed accountancy fraud at retailer Steinhoff.

True, in all of these cases, the investment managers made money from their short positions. But they also actively lobbied company management and pushed problems into the public eye, leading to their eventual resolution – and to the tightening of laws and regulations.

What has worked for corporate governance can also work for environmental and social matters. 

With hedge funds now adding expertise in alternative data to their ability to short stocks, they can – and increasingly are – helping improve the corporate world’s ESG credentials. 

They are better equipped to uncover companies that are making good progress on their ESG journey, and hold to account those that may be guilty of “greenwashing” – or failing to live up to their promises – as well as those that are simply falling behind.

Talking of ESG

Mentions of "ESG" in companies’ earnings transcripts, globally

 

If one of the goals of responsible investing is to improve corporate behaviour, it could be argued that responsibly taking a short position in a stock could have a more positive effect than holding an underweight position or excluding it from a long-only portfolio. Hedge funds can – and do – engage directly with the management of a company whose stock they are shorting.

Crucially, it is because their actions have a more direct impact on a company’s cost of capital that hedge funds are more likely to succeed in changing firms’ ESG practices.

At Pictet Asset Management, we have incorporated ESG considerations into the investment processes and risk management of all our hedge fund strategies. While investment teams may still purchase companies with weaker ESG credentials (or express a negative view on ESG leaders), their focus is on whether investors are adequately compensated for known risks or whether there is strong potential for change in a company’s medium- and long-term prospects. 

In Europe, for example, the European Union’s pandemic recovery plan has the potential to disrupt almost every industry and drive a previously unimaginable amount of capital towards renewables, sustainable infrastructure and other green initiatives. As sustainable investment booms, ESG is likely to become a much bigger driver of performance, which points to a rich seam of investment opportunities for hedge funds.

Our Pictet TR-Agora, a catalyst-driven market neutral strategy, for example, considers sustainability as one of the potential sources of a stock’s excess return alongside other major 'catalysts' such as company restructurings, M&A and shifts in earnings expectations.

The strategy’s distinctive approach means it can uncover ESG investments in unusual places. Such as the oil sector. Here, our portfolio managers have discovered some European integrated oil companies are already much more advanced in repositioning towards a low carbon economy compared to their peers elsewhere in the world, and have ambitious plans to continue along that path.

This can create attractive opportunities to express a relative value position, particularly if the investment thesis also has a strong financial case.

So, rather than taking a buy-and-hold approach involving, say, a long position in clean energy stocks and short one in oil companies, our approach is more dynamic and nuanced, actively aiming to generate excess returns by looking beyond conventional investments.

Our global market neutral Pictet TR-Aquila, meanwhile, avoids sectors that are sensitive to the economic cycle and therefore naturally excludes some of the most heavily polluting industries such as oil & gas, commodities, and transport. Because it has lower exposure to environmental laggards, the strategy focuses more on corporate governance practices when conducting ESG assessments as part of its fundamental analysis of potential investments.

Uncovering governance red flags serves two broad purposes. First, it can serve as a trigger for a new short position. Second, it could lead to a reassessment of a long position.

Our experience suggests, for example, that the departure of a chief financial officer coupled with changes in a firm’s accountants or disclosure policies have consistently been a warning sign in certain industries, in particular the retail sector. When red flags do appear, active dialogue with the company is vital. How responsive a company is to investor concerns can either offer reassurance about an investment (as is currently the case with a major US wireless networks operator that is working hard to address legacy issues) or lead to a divestment (as was recently the case with a Middle Eastern hospital company, which has since gone bankrupt).