Questions Every Allocator Should Ask a Manager about ESG

While ESG is a popular topic for discussion, there is not a lot of common ground when it comes to the details. ESG investing is still in the early innings for most hedge fund allocators, especially given the wide-ranging objectives and definitions employed by all participants in the space. Not only do investors need to validate their research findings, they need to ask the right questions to begin with. Specifically, allocators need to get at the granularity of how the specific hedge fund manager is executing the strategy. Below we offer some questions we suggest that allocators ask when discussing ESG.

WHY?

Why is a manager utilizing ESG?

Managers have different motivations for getting involved in ESG – some are more interested in raising assets rather than being a true steward of capital. To better understand managers’ motivations, investors should ask about:

• Demand from funds’ underlying clients/stakeholders/plan participants

• Alignment with overall mission

• Evolving policies and regulations

• Enhanced return potential

• Improved risk management

• Other reasons

Why does the strategy work in a hedge fund format?

At its core, ESG is still inherently a long-only strategy. Specifically, there is little agreement on how managers will execute short selling. To clarify, investors should ask managers:

• What is your approach on the short side?

• How does short selling fit within your existing strategy?

• Can you be short a company that is scored high from an ESG perspective (e.g. a wind and solar business)?

WHAT?

What ESG concept(s) does a manager plan to incorporate?

Certain approaches are more rudimentary and passive, while others are more thoughtful and active in nature. To parse the former from the latter, investors should ask about:

• Exclusions/divestment – avoiding or excluding exposures relating to “sin industries” like alcohol, tobacco, gambling, coal, and weapons

• Screening – filtering the universe using ESG factors to identify companies with good/improving and poor/deteriorating metrics

• ESG integration – taking a holistic approach that incorporates ESG considerations into the existing fundamental process

• Engagement & voting – selecting investments based on shareholder activism and shareholder voting patterns regarding ESG issues

• Thematic opportunities – focusing on a specific theme like climate change or carbon efficiency

• Impact investing – focusing on investments that offer a positive outcome on society

What steps is a manager taking to incorporate ESG into the investment process?

ESG is still new to a lot of managers. Some are taking extra steps when it comes to socially responsible investing. Others are doing the bare minimum required to be considered an ESG fund. To tell the difference, some questions to ask include:

• Are additional hires required?

• Is there a written policy outlining the integration of ESG factors into the investment process?

• Is there anything proprietary about the manager’s approach? For example, has the manager developed a unique, proprietary scoring system to identify ESG leaders and laggards?

• How much qualitative and quantitative analysis will be performed on top of the company reported data?

HOW?

How is a manager thinking about data?

More so than other areas of the hedge fund landscape, there is a lack of clear standards in the ESG marketplace – data is limited, lacks uniformity and is subject to vastly different methods of interpretation. To understand how a manager is using data, investors might ask:

• Do you use external data sources or third-party ratings?

• How are you utilizing that data?

• How far does the data go back?

• Have you validated the data that you are using, or do you take it at face value?

How has ESG contributed to your portfolio?

There is a debate about the ability to make money in ESG – it is not clear whether ESG funds offer better performance and better alpha generation than non-ESG funds. To get to the heart of this debate, investors should ask managers:

• Can you achieve better returns than traditional hedge funds?

• Does ESG offer alpha opportunities?

• Are you managing to a benchmark?

• Are you measuring how the ESG changes impact performance?

In all areas of hedge fund investing, we advise our clients to get beyond the buzzwords and into the details. In an emerging investment area like ESG, that need is particularly acute. As both allocators and managers become more educated on the topic, we expect to see more standardization and increased flows into the space.