As climate change and inequality are dominating the media and public agenda, a growing number of institutional investors are basing their investment allocations on environmental, social and governance (ESG) criteria and are forcing alternative funds to take these factors into account in their portfolios.

A survey of 135 institutional investors, hedge fund managers and long-only managers with total assets of US$6.25 trillion in 13 countries showed that investors increasingly expect their asset managers to generate high returns and consider the environmental and social risks associated with their investments.

The sustainable investment report published by KPMG, the Alternative Investment Management Association, the Chartered Alternative Investment Analyst Association and CREATE-Research was released at the Cayman Alternative Investment Summit last week.

“The traditional risk-return equation is being rewritten to include ESG factors,” said Anthony Cowell, head of Asset Management, KPMG in the Cayman Islands and co-author of the report. “In the hedge fund industry, ESG has gone from being a nice-to-have to a must-have.”

Some 45% of institutional investors now base their investments in ESG-based hedge funds on the view that they present opportunities to generate alpha, or outsized returns, while also offering a more defensive portfolio that looks beyond the blind spots in markets that are slow to price in ESG risks, the report found.

Because more investors now believe ESG investing is serving their own long-term interest as well as society’s, hedge fund managers have responded by implementing ESG processes through policies, committees, research and data.

In terms of ESG implementation, 15% of the surveyed hedge fund managers said they are at a mature stage, 44% said they are “in progress”, while 31% are still raising awareness and another 10% of managers have not implemented any of the social, environmental and government factors.

Of the funds that are responding to investor demands, 52% make ESG criteria part of the investment process and 50% exclude securities that sit uncomfortably with the personal values of investors.

Changing attitudes

Panellists at the Cayman Alternative Investment Summit confirmed that attitudes in the industry have changed in the past year.

Asha Mehta, Acadian Asset Management. Photos: Cayman Alternative Investment Summit

Asha Mehta, director of responsible investing at Acadian Asset Management, said, “In the last 12 months there has been a sea change in the way ESG investing is perceived and how it is invested upon within the industry broadly.”

Acadian, a quant fund that manages global equities, she said, has incorporated intangible-related issues and exogenous variables in its models since well before the theme of ESG was coined a little over a decade ago.

“We do so in part because we recognise we have an active role in terms of stewardship but also and largely because we do see latent alpha embedded within ESG,” Mehta said.

The fact that the global investor base wants to see ESG expressed in their investment mandates and more money is flowing into funds that take environmental and social issues into account, is partly due to more millennials and women allocating investments, she added, as they are more likely to invest according to their personal values.

Andrew Weir, the China-based global head of asset management at KPMG, believes “sustainability is set to reshape the ecosystem of capital markets and the behaviours of their participants”.

While it will require a shifting mindset from the way investing has been done historically, he said in a press statement it will become “the gold standard in investing”.

However, currently only 29% of hedge fund managers and only 11% of institutional investors are reporting positive results, mainly because it is difficult to establish a direct link between environment, social and governance factors and investment outcomes.

“Creating the necessary infrastructure of data, skills and technology is proving challenging,” said Amin Rajan, CEO of CREATE-Research and co-author of the report. “Progress may not be enough, but it remains exponential. Investors and their managers are having to climb a steep learning curve via learning-by-doing,” he added.

Anna-Marie Wascher, Flat World Partners

The ambiguity around the data leads to the suspicion that sustainable investing results in lower returns, something that Anna-Marie Wascher, founder and CEO of Flat World Partners, said is frustrating.

“My continuous view is that it is alpha generating, when you truly understand and interpret the data.”

Arguments of the past that investment managers as fiduciaries could not invest in ESG because the returns were lower are largely off the table.

Kareen Stangherlin, CEO of Zelos Capital, said, “I used to hear frequently that we cannot do ESG because we are fiduciaries. But last year the CFA Society published a position paper that clarified CFA charterholders should be incorporating ESG into their investment analysis and it is consistent with fiduciary duty.” Most other professional organisations have followed suit.

Kareen Stangherlin

Given the pressure from institutional investors, fund managers are increasingly expected to act as agents of change and a ‘carrot and stick’ approach to corporate engagement is emerging. The sustainable investing report found that investors and managers have increasingly collaborated with their peers and external advocacy groups in promoting ESG-related goals among the target companies.

For the time being, however, divestments remain rare in cases in which such cooperation does not yield visible results.