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Hedge Funds, Sustainable Investing, and the Data Gap

KPMG and CREATE have collaborated on a new report on the involvement of hedge funds in sustainable investing, which they define as investing that aims at three interlocking results: avoid harm and mitigate ESG risks; benefit all stakeholders; and contribute solutions to societal problems.

The involvement of hedge funds in sustainable investing has been, as the report observes, thus far incremental.

The report examines three issues. What is the state of progress at present on the implementation of sustainable investing? What barriers are holding back the pace of progress? And, how are the evolving best practices addressing these barriers? The answers are still tentative: a lack of reliable data and aiming to create a database through industry codes and principles.

State of Progress

Some quick numbers: 85% of the hedge fund managers surveyed agree that institutional investors are the biggest drivers of demand for ESG concerns. Only 15% of managers thus far have ESG factors embedded across their strategies; and nearly two thirds (63%) agree that progress is hampered by the lack of robust templates, consistent definitions, or reliable data.

What do the institutional investors who are doing the driving have to say? Three quarters (75%) say it is still “too early to decide whether sustainable investing delivers double bottom-line outcomes,” that is, succeeding as both alpha seekers and engines for a better world. Roughly half (49%) complain of a lack of consistent quality data.

Some institutions see sustainable investing as a defensive move. They believe that the market has been too slow to price in ESG risks, and that this raises important tail risks, such as a sudden headline-driven market move against carbon-emitting power sources. Accordingly, having sustainable investment in the portfolio is risk management.

Missing Data as Obstacle

What, then, are the obstacles to greater hedge fund participation in sustainables?

The most important is the aforementioned lack of consistent high-quality data. Research methodologies are opaque, ratings are unreliable, and so forth. More than a third of hedge funds (36%) say that there exists “confusion over industry terminology,” more than a sixth (18%) cited a “shortage of knowledge or expertise.” Relatedly, 9% worry about a “lack of consensus from internal stakeholders.”

However, there are some (both hedge funds and their investors) who take the view that the inconstant quality of the data is not a red flag, but an invitation. After all, alpha seeking is largely a matter of seeking inefficiencies and exploiting them, closing various windows.

Amin Rajan, founder and CEO of CREATE, expands on this question of the reliability of data in a post on his blog. He says that there is a lacuna of data on three foundational issues: materiality (how material climate change is to a company’s financial performance); intentionality (whether the company is aiming at sustainability through its products and services); and additionality (whether it is generating societal benefits in addition to financial benefits).

Another obstacle is what Rajan calls “quarterly capitalism,” that is, an incentive structure with a time horizon of just three months. This turns markets, in his words, into “a vehicle for cash distribution and balance sheet management” rather than a way for entrepreneurs to raise money for the pursuit of their visions.

Evolving Best Practices

Returning to the language of the report: it postulates that as the hedge fund industry becomes more institutionalized its practices in the sustainability space will draw more scrutiny. Though the business model of hedge funds will continue to be dependent on producing acceptable financial outcomes for its investors, it “may be expected to deliver nonfinancial outcomes too, over time.”

There is a good deal of discussion of greenwashing. This is the precise opposite of “best practices.” Greenwashing is the dressing up business-as-usual as something ESG sensitive. An issuer might, for example, put recyclable bins in the company cafeteria. That hardly amounts to an ESG strategy. Likewise, a hedge fund management might put a new label on an old fund to make it sound “green” without re-jiggering the investment process at all (or might simply buy the securities of that company with the new recyclable bins in its cafeteria).

The authors of the report are optimistic that “concerted action now in progress by data vendors, index providers, asset managers and listed companies to improve data quality and their definitional consistency is expected to ease the problem over time.” There is tighter regulatory oversight, which is speeding this process, particularly in Europe.

Further, institutional investors where ESG is part of the culture have come to see greenwashing as the teething pains of a better form of investing.

Rajan also is optimistic about the bottom line of such inquiries, writing: “It is hard to believe that climate change will not emerge as a compensated risk factor before long.”