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Hedge fund managers who haven’t started incorporating ESG (environmental, social, governance) issues into their investments will have to start doing so soon. A new survey indicates that 41% of U.S. investors consider ESG as a factor when selecting which hedge funds to invest in.

A trader blows bubble gum during the opening bell at the New York Stock Exchange (NYSE) on August 1, … [+] 2019, in New York City/ (Photo by JOHANNES EISELE/AFP via Getty Images)
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Additionally, one of the firms that conducted the survey warned that ESG could be in the process of inflating like a bubble.

HFM conducted the survey with The Allocator. They found that the investor types most likely to consider ESG when selecting fund managers were funds of funds at 67% and public pensions at 52%. The least likely investor types to consider ESG were family offices at 32% and corporate pension funds at 11%.

This may not be much of a surprise because family offices and corporate pension funds are mostly insulated from political opinion and have more opaque structures and investment strategies. However, HFM said this could change as younger generations and beneficiaries start to influence investment decisions at these private entities.

The firm also said that overall, the younger and more sophisticated the investor base, the more likely the investors are to consider ESG when choosing fund managers. HFM added that for now, ESG might not be a significant part of conversations with private wealth investors in the U.S., but fund managers should start laying the foundation for engagement on the issue in the near future.

The survey indicated that the two asset classes most likely to be affected by ESG considerations were private and public equities at 41% and 40% of U.S. investors, respectively. Real estate was in third place at 33%, followed by real assets at 31%, hedge funds at 30% and private credit at 28%. Among hedge funds, those following a long/ short equity strategy led the way in impacts by ESG. Meanwhile, funds trading instruments other than stocks were mostly untouched by ESG policies among U.S. investors.

HFM explained that the idiosyncrasies of each asset class are driving the application of ESG to those various asset classes. For example, governmental pressure on developers is driving more of the ESG impact on real estate than investor sentiment.

HFM noted that the social impact of real estate comes through affordable housing in U.S. suburbs, rehabilitating public spaces and building new green structures in urban areas. All of these elements of the social impact factor into governmental interventionist policies. The firm added that investors will have to “reinvent aspects of their traditional investment models to match Democratic Party regulatory changes.”

The survey also indicated that incorporating ESG factors into equity investing is more sophisticated and integrated than in other asset classes. HFM explained that quantitative, fundamental and smart beta strategies are approaching passive strategies in assessing variables and generating excess risk-adjusted returns.

The three most shunned sectors were tobacco, oil and gas, and weapons. According to HFM, the data correlates with the growing number of U.S. investors with either a dedicated ESG capital pool or an ESG overlay on all their investors. Twenty-four percent of investors now say they either have a dedicated pool or an ESG overlay.

However, the firm added that one aspect of ESG equity investors that haven’t been studied much is the “growing pool of money pouring into ESG assets.” HFM warned that this growing pool could be inflating ESG into a “mini bubble.”

Another challenge pertaining to ESG is the lack of a track record of fund managers in this area. HFM also said issues relating to how funds can fid under the Biden administration’s criteria and the European Union’s new Sustainable Finance Disclosure Regulation are another concern.

The EU’s new rules classify funds as either sustainable or non-sustainable based on criteria that managers must follow carefully to avoid acquisitions that they are greenwashing to attract business.

HFM noted that politics are a major driver of ESG uptake in the U.S. Developed economies continue to push toward net-zero carbon. Meanwhile, one focus area for U.S. investors is the growing number of funds seeking to generate alpha from the climate transition. ESG enthusiasts, Congress and the president have now accepted the theory that climate change is a significant risk for an institutional investor’s portfolio.

Additionally, President Joe Biden’s executive order on climate-related financial risk over the summer provided public pensions and financial institutions two new ways to consider how climate change impacts their portfolio. As already stated, public pensions and financial institutions are the second and third, respectively, most likely of the surveyed groups to be influenced by ESG.

The two new ways ESG can impact an investment portfolio include physically, like through fixed assets that affect a company’s supply chains, operations and transition risks. The other potential impact of ESG involves changes in policies and technology as the economy shifts toward a low-carbon future.

HFM also found that 32% of U.S. allocators have a formal ESG policy. Investor types most likely to have a formal ESG policy were funds of funds at 50%. Additionally, 27% of public pensions in the U.S. reported that ESG impacted their hedge fund investments.

The survey also indicated that some investor types are blocked from investing in certain sectors due to their ESG policy. For example, 40% of non-profit organizations are barred from investing in tobacco companies, while 13% of foundations and endowments can’t invest in fossil fuels. Eleven percent of family offices and 10% of public pensions are also barred from investing in fossil fuels.

In fact, fossil fuels are the one sector investors are most likely to be barred from investing in due to their ESG policy. HFM found that charities and non-profit medical institutions have gotten more committed to ESG amid pressure from activism during the Trump administration. The firm expects the prohibition on tobacco, oil and gas, and weapons will increase over the next four years, alongside growing prohibitions on alcohol and coal.

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