ESG ALPHA
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New Approaches in Socially Responsible Investing
Despite significant growth in the use of hedge funds by investors, there has been only minimal
use by SRI/ESG based investors. I hope that this website will generate some thoughtful
discussion about the use of hedge funds and other alternative asset classes by SRI investors
and hopefully motivate some investors to begin allocating to this class.
What are Hedge Funds?
Generally speaking, hedge funds refer to non-publically traded pooled investment vehicles that,
in addition to traditional security ownership, may use one or more alternative investment
strategies such as security shorting, leverage, derivatives, and arbitrage to enhance returns
and/or control risk. They may not be measured against a specific benchmark and may invest in
non-traditional asset classes such as currencies, distressed securities and/or a range of illiquid
investments.
While there are many different types of hedge funds, four of the most common ones are the
following.
The use of leverage (borrowing money to invest) is used to varying degrees across these and
other strategies. The degree to which a fund uses leverage in a portfolio should be carefully
monitored by investors as more leverage leads to more volatility of returns.
The size of the hedge fund market has doubled to over $1 trillion over the past five years. At
the end of 2005 there were over 9,000 funds in existence. Hedge funds now account for over
10% of the $10 trillion pooled investment market.
Hedge funds managers argue that, because they have a wider breadth of investment options
and tools at their disposal, they can provide returns above that of traditional asset classes with
lower risk. Indeed, a review of performance data suggests that this statement is correct*. That
said, there are three key disadvantages to hedge fund investing. One disadvantage is that,
while regulatory scrutiny of hedge funds is increasing, they are still not subject to the same
level of scrutiny/transparency as other pooled vehicles such as mutual funds. Thus, there is a
higher risk that the product delivered may not be consistent with the product described.
Another disadvantage is that fees for hedge funds tend to be significantly higher than those
associated with mutual funds. Lastly, hedge funds frequently have lock up periods ranging
from six months to three years.
Who Can Invest in Hedge Funds?
Typically, shares will only be offered to 'accredited investors'. To become an accredited
investor, you and your spouse need a combined net worth of $1 million which can include the
estimated value of your home. Alternatively, you'll need an individual income of $200,000 or a
joint income of $300,000. Some hedge funds are required to set the bar a little higher. To
invest in a fund with more than 99 shareholders, you need to be in the wealthier 'qualified
purchaser' category (you need to have $5 million in investments not including a primary
residence or any property used for a business).
What is ESG Investing?
ESG investing refers to any investment approach that incorporates environmental, social and
corporate governance factors. In the Social Investment Forum’s 2006 biannual report on
socially responsible investing, it is estimated that $2.41 trillion (9.9%) of the $24.4 trillion under
professional management in the U.S. is related to ESG investing. The terms ESG and SRI are
now used interchangeably to describe this approach. These portfolios, be they mutual funds or
separately managed accounts, use one or more of three strategies: ESG screening,
shareholder advocacy and community investing.
The key driver for this industry has always been the investor desire to invest in businesses
which reflect specific values. For centuries, religious investors have avoided investing in "sin"
industries which typically include alcohol, tobacco, and gaming businesses. Social and
environmental movements in the 1960s served to heighten investor awareness related to
human rights, the defense industry and environmental protection. What investors screen for
has evolved over time. For example, divestment from South African companies is no longer an
active screen. However, climate change, human rights, and corporate governance screens
have become far more common screening criteria.
A more recent driver of this industry is the emerging view that using ESG criteria may contribute
to positive alpha, or out performance versus a benchmark. Historically, critics of ESG claimed
that investing using these criteria was a violation of fiduciary responsibility. They argued that
an asset manager’s sole responsibility is to maximize risk adjusted return and that ESG criteria
are an unnecessary constraint on achieving this objective. There is a growing body of
academic research that suggests that the contrary may be true.
What are ESG Hedge Funds?
Simply put, they are hedge funds which incorporate ESG factors in their respective investment
processes. Some funds are comprehensive in their inclusion of these factors while others may
just be focused on one or two of these areas. For example, there are several hedge funds
which are just focused on environmental factors.
A key distinguishing factor of ESG hedge funds, as compared to traditional ESG funds, is that
they have more flexibility in the way they use ESG factors. Most of the existing ESG hedge
funds fall into the category of long-short hedge funds. In many cases, these funds are as likely
to use ESG screening on the long side of their portfolio as they are on the short side.
Shouldn't This Website look at other Asset Classes Beside Hedge
funds?
The short answer is yes. As mentioned above I have chosen to focus primarily on hedge funds
because they are currently the dominate alternative asset class. That said, ESG related
private equity is also an important and growing area. I hope to dedicate more resources to this
area in the future.
Who created ESG Alpha?
use by SRI/ESG based investors. I hope that this website will generate some thoughtful
discussion about the use of hedge funds and other alternative asset classes by SRI investors
and hopefully motivate some investors to begin allocating to this class.
What are Hedge Funds?
Generally speaking, hedge funds refer to non-publically traded pooled investment vehicles that,
in addition to traditional security ownership, may use one or more alternative investment
strategies such as security shorting, leverage, derivatives, and arbitrage to enhance returns
and/or control risk. They may not be measured against a specific benchmark and may invest in
non-traditional asset classes such as currencies, distressed securities and/or a range of illiquid
investments.
While there are many different types of hedge funds, four of the most common ones are the
following.
- Long/Short Equity - Managers build portfolios with both long and short stock positions. Long positions
are stocks which managers believe will appreciate over time and short positions are stocks that they
believe will depreciate over time. Short positions are structured in such a way that the portfolio profits
as a stock declines in value. Some Managers will specialize in specific areas, defining their
investments based on categories such as capitalization, geography and/or economic sectors. - Market Neutral - Managers offset 100% of long positions with an equal value of short positions so,
theoretically, the investor has no exposure to the overall level of the market. Performance is linked
primarily to the managers ability to choose stocks that will either rise or decline in value. - Arbitrage - These managers attempt to take advantage of pricing discrepancies between securities.
Common forms of arbitrage include merger arbitrage (pricing discrepancies in the stocks of the
combining companies), fixed income arbitrage (discrepancies in the price of related fixed income
instruments), security class arbitrage (discrepancies in valuation between the stock, convertible bonds,
preferred stock and/or warrants of a specific company). - Global Macro - Managers have very few constraints on how they invest and, essentially, invest where
they see opportunity.
The use of leverage (borrowing money to invest) is used to varying degrees across these and
other strategies. The degree to which a fund uses leverage in a portfolio should be carefully
monitored by investors as more leverage leads to more volatility of returns.
The size of the hedge fund market has doubled to over $1 trillion over the past five years. At
the end of 2005 there were over 9,000 funds in existence. Hedge funds now account for over
10% of the $10 trillion pooled investment market.
Hedge funds managers argue that, because they have a wider breadth of investment options
and tools at their disposal, they can provide returns above that of traditional asset classes with
lower risk. Indeed, a review of performance data suggests that this statement is correct*. That
said, there are three key disadvantages to hedge fund investing. One disadvantage is that,
while regulatory scrutiny of hedge funds is increasing, they are still not subject to the same
level of scrutiny/transparency as other pooled vehicles such as mutual funds. Thus, there is a
higher risk that the product delivered may not be consistent with the product described.
Another disadvantage is that fees for hedge funds tend to be significantly higher than those
associated with mutual funds. Lastly, hedge funds frequently have lock up periods ranging
from six months to three years.
Who Can Invest in Hedge Funds?
Typically, shares will only be offered to 'accredited investors'. To become an accredited
investor, you and your spouse need a combined net worth of $1 million which can include the
estimated value of your home. Alternatively, you'll need an individual income of $200,000 or a
joint income of $300,000. Some hedge funds are required to set the bar a little higher. To
invest in a fund with more than 99 shareholders, you need to be in the wealthier 'qualified
purchaser' category (you need to have $5 million in investments not including a primary
residence or any property used for a business).
What is ESG Investing?
ESG investing refers to any investment approach that incorporates environmental, social and
corporate governance factors. In the Social Investment Forum’s 2006 biannual report on
socially responsible investing, it is estimated that $2.41 trillion (9.9%) of the $24.4 trillion under
professional management in the U.S. is related to ESG investing. The terms ESG and SRI are
now used interchangeably to describe this approach. These portfolios, be they mutual funds or
separately managed accounts, use one or more of three strategies: ESG screening,
shareholder advocacy and community investing.
- ESG Screening is the practice of including, excluding or ranking companies on the basis
of environmental, social or governance criteria. Screening criteria typically includes
employer-employee relations, environmental practices, and the safety and utility of
products/services. - Shareholder advocacy describes the actions of socially aware investors in their role as
shareholders. These efforts include dialogues with companies on issues of concern, as
well as filing and voting on proxy resolutions. - Community investing provides capital for communities that are under served by
traditional financial services. It provides access to credit, equity, capital and basic
banking products that these communities would not otherwise have.
The key driver for this industry has always been the investor desire to invest in businesses
which reflect specific values. For centuries, religious investors have avoided investing in "sin"
industries which typically include alcohol, tobacco, and gaming businesses. Social and
environmental movements in the 1960s served to heighten investor awareness related to
human rights, the defense industry and environmental protection. What investors screen for
has evolved over time. For example, divestment from South African companies is no longer an
active screen. However, climate change, human rights, and corporate governance screens
have become far more common screening criteria.
A more recent driver of this industry is the emerging view that using ESG criteria may contribute
to positive alpha, or out performance versus a benchmark. Historically, critics of ESG claimed
that investing using these criteria was a violation of fiduciary responsibility. They argued that
an asset manager’s sole responsibility is to maximize risk adjusted return and that ESG criteria
are an unnecessary constraint on achieving this objective. There is a growing body of
academic research that suggests that the contrary may be true.
What are ESG Hedge Funds?
Simply put, they are hedge funds which incorporate ESG factors in their respective investment
processes. Some funds are comprehensive in their inclusion of these factors while others may
just be focused on one or two of these areas. For example, there are several hedge funds
which are just focused on environmental factors.
A key distinguishing factor of ESG hedge funds, as compared to traditional ESG funds, is that
they have more flexibility in the way they use ESG factors. Most of the existing ESG hedge
funds fall into the category of long-short hedge funds. In many cases, these funds are as likely
to use ESG screening on the long side of their portfolio as they are on the short side.
Shouldn't This Website look at other Asset Classes Beside Hedge
funds?
The short answer is yes. As mentioned above I have chosen to focus primarily on hedge funds
because they are currently the dominate alternative asset class. That said, ESG related
private equity is also an important and growing area. I hope to dedicate more resources to this
area in the future.
Who created ESG Alpha?
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