Economists in general, and scholars of finance in particular, have long been concerned with the “agency problem,” the conflict of interest inherent in any relationship where X is expected, and perhaps required by law or contract, to act in the best interest of Y. The problem exists because, for example, stockholders expect a corporate management to act on their behalf, and limited partners expect a fund management to act on theirs. But it ain’t necessarily so. Deterrence, through litigation or even criminal law enforcement, has always been a poor solution to the problem. Where temptations are great, the tempted will be willing to run both of those risks. A better idea is to align the incentives. This is the idea behind a library full of standard lines: “We’ve got skin in the game;” “We keep managers and investors on the same page;” “We eat our own cooking.” As sensible as it all sounds, though, aligning incentives is a tricky issue, and the bright solution of one decade is the legacy problem for the following decades. Socially Responsible Investing Unsurprisingly, the agency problem pops up in the world of socially responsible investing. In the context of hedge funds, we can sensibly as: do hedge funds that represent themselves as abiding by the United Nations Principles for Responsible Investment actually walk the ESG walk as well as talking the talk? They market on the basis of the UN PRI. Do they actually pursue the PRI and expose themselves to ESG assets? A recent study by Hao Liang and others, available at SSRN, observes that hedge funds that market on the basis of PRI, signers of the PRI pledge, underperform other hedge funds. But it contends that this is not the fault of their adherence to PRI. It is the fault of their marketing opportunism. They talk the ESG talk for the inflow, but then fail to follow through, and underperform because the mismatch. This is not an SRI failure, then, but an old-fashioned agency problem. Hao Liang is affiliated with Singapore Management University, the Lee Kong Chian School of Business, as is another of the authors on the paper, Melvyn Teo. The other author is Lin Sun, of Fudan University, Shanghai, China. Finding a Way In The article begins with a quote from a Bloomberg story of a little more than a year ago: “As almost $31 trillion has flowed into investment funds and strategies that emphasize good governance and socially responsible business practices, hedge funds have largely found themselves left out. . . . They are starting to find their way in.” For the purposes of this study, hedge funds stand out among other possible alternative investments, distinct from PE, real estate funds, farmland, etc., because of their transparency. They “typically report monthly returns to commercial databases, allowing researchers to cleanly measure investment performance and evaluate the investment implications of PRI endorsement.” This allows for the use of hedge funds for a study of the consequences of that endorsement. If one of the consequences is that investors who want exposure to ESG get lied to and get suboptimal performance, then the hedge fund space is a good place to show this. And, indeed, the data indicates that though PRI signers in general do lag non-signers, the lag is less when the signers are in fact trying to comply. High ESG-signer hedge funds lag non-signing hedge funds by a modest 0.54% per annum in their risk-adjusted performance. Low-ESG signers lag non-signers by a monumental 7.72% per annum. Findings that Resonate The simplest explanation here is that low-ESG signers, those who are by virtue of that situation betraying the trust of their investors, are quite likely to betray that trust in other ways as well. These findings “resonate,” as the authors put it, with findings concerning other institutions: other scholars have found that social responsibility (at least as a feature of marketing) also corresponds to below-normal, risk-adjusted performance for mutual funds and endowment funds. In those case, as with hedge funds, many have been tempted to attribute this to the SRI program itself: maybe the “sin funds” have the right idea and excluding the sins excludes some of the performance. But Liang et al., say “not so fast!” They opened up the question of whether the underperformance is an agency problem, and further research should look to this in those areas.
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