I recently had the opportunity to be interviewed by Belinda Hoff, a researcher at the BC Institute for Responsible Investing. For this blog entry I’ve posted her questions and my responses. However, this is not a transcript. I’ve added some additional commentary to clarify and/or emphasize some responses.
What does it mean to be a socially responsible hedge fund?
- An SRI hedge fund incorporates ESG factors into the fund management process to generate alpha.
What are the three most important questions when considering an approach that incorporates social, environmental and governance issues into the evaluation of hedge fund investments?
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What is the manager’s “execution edge”? Why do they think they can demonstrate outsized returns, specifically in relation to ESG impacts?
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What is the ESG strategy used? For example, a fund might use a thematic approach to investing – structuring long positions in companies that address obesity and its comorbidities and offsetting these with short position in candy and/or fast food companies. Quantitative approaches which incorporate industry standard measures of environmental and/or governance quality can also be used.
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One needs to consider how they feel, as an investor, taking short positions, and possibly benefiting from the poor ESG performance of a company.
Why should SRI investors consider investing in hedge funds?
- SRI investors are underweight in the HF sector relative to mainstream institutions where fixed-income is eroding and alternative assets have increased from 10-20% to 40% of holdings. The particular benefit of hedge funds is that the returns are not correlated to market performance as much as other asset classes (including other alternative asset classes). This means that even in a poor market, HFs have the potential to post good returns.
General comments about hedge funds (not SRI specific). -
There is broad dispersion among fund managers: from very good to very poor. Despite this, on average hedge funds have provided good risk adjusted returns compared with the S&P 500.
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To minimize the risk of selecting a potentially poor fund, one needs to understand the performance being presented – what is the investment process that drives performance? Transparency of the fund (process, holdings, team) is critical as this allows understanding of the value added.
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There are many types of hedge funds, so one needs to do their homework. It is important to achieve diversification in hedge fund investments. It is very risky to invest in just one fund or one type of hedge fund. Smaller investors that can not directly buy multiple funds should consider an investment in a fund of funds.
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Fee structure is typically higher than mutual funds. It is important to consider returns net of fees.
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Investors are starting to look more at the separation of alpha and beta. Beta being the market driven return vs. alpha which is the added return that good management provides.
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For many hedge funds, compensation is based on total return (beta+alpha) and not just value added (alpha) by a manager.
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If possible, one should make sure that they are paying for only alpha returns, not beta, which can be achieved with a low cost index funds or exchange traded fund. One example of how to measure for equity alpha is to measure performance against the Domini 400.
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Lock-in periods vary, but can be anywhere from 1 to 5 years. Managers justify longer lock-ins by saying they need time to realize specific investment opportunities.
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Lock-in periods and fee structures are getting more negotiable.
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Young hedge funds tend to do better than mature ones as there is a greater performance driven incentive for smaller funds. Investors might want to consider having an allocation to younger funds. Some fund of funds also have an emerging fund category.
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Hedge funds are more flexible than other investment funds because they are private investment vehicles. Public mutual funds have greater restrictions in terms of charter and by laws.
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HFs are more willing to take on debt (leverage). Monitor the degree of leverage in a fund. Higher leverage equals higher volatility of returns.
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Activist HFs can make illiquid or concentrated investments to get board level influence. High fees associated with performance can encourage this type of behaviour.
What are the practical limitations associated with considering ESG issues in a shorting context? -
Shorting as a device to encourage more responsible practices should not be overrated. Unless the investor has the ability to establish a sizable short position it will not have much impact on share price. Companies tend to respond better to a carrot rather than a stick (proxies). There is at least one fund, Green Cay Asset Management, which will tell companies that they are shorting it and why. However this approach has less impact than active ownership as a shareholder.
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In addition, for shorting to be successful, the ESG factor screened for must be correlated with value destruction and result in the company’s stock price going down.
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Investors need to attempt to benefit from bad decisions rather than bad luck. ESG factors can be used to identify companies where poor decisions are more likely.
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Shorting can add liquidity and rationality to the market. This in turn can contribute to the stock price being affordable to more people
How do you measure and report the social or environmental impact of the investment? -
One could look at how quickly a company improves on Innovest scores or other ESG scoring systems.
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A more qualitative and, thus, time consuming method would be to look at improvements by using a company’s CSR report.
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Measure the support for shareholder resolutions.
How do investors invest in funds – what is the structure of the investment? -
Investors buy directly into the funds or use fund of funds.
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HFs are only available to accredited investor or qualified purchaser.
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Investors can also consider using Bill Mill’s approach which he uses for the Catholic values based Good Steward Fund. He works directly with non-SRI HF managers who create SRI versions of their non-SRI products for his clients.
