Taking the pulse on ESG: hedge funds in South Africa

The RisCura Sustainability Team: Brooke Leaf-Wright, Chris Rezelman and Susanna Yang

In recent years, ESG investing has been on the increase both internationally and in South Africa – including within the hedge fund space. However, 2022 has seen ESG investing take a downturn. The Russia-Ukraine conflict drove up energy prices and saw markets scramble for oil and gas, concerns over greenwashing caused investors to lose faith in ESG, and recent rulings in the states of Florida and Texas prohibited ESG investing in pension funds. These all appear to be blows to the industry.

At RisCura Analytics, we generate daily reports for most of the South African hedge fund market, affording us the opportunity to survey several key hedge fund managers to assess the degree of ESG integration within their processes. We sought to identify similarities to international markets, unpack perceptions and misconceptions, and look at the challenges and opportunities available to hedge funds across the ESG landscape. Despite a tough year for ESG, our results showed favourable uptake of ESG integration among our managers.   

Of the respondents we surveyed, 82% stated that they incorporate ESG into their investment decision-making, and 67% indicated that they consider ESG issues to be extremely important to investment decision-making processes, integrating ESG into both long and short positions. Only 18% of respondents said ‘no’ to factoring ESG into their investment decision-making. This same 18% also indicated that they were not likely to do so in the future. Where ESG integration was not incorporated we found the reasons were generally tied more to negative perceptions about ESG than constraints relating to technical expertise, costs, or mandate. Of those who said ‘no’, 50% had concerns regarding ESG data. Concerns around the consistency and reliability of sustainability data are not unique to South Africa and can understandably lead to some hedge fund managers being reluctant to include ESG in their investment decision-making. However, guidelines promoting better transparency, accessibility and comparability of ESG data are increasing; these include the Taskforce for Climate Related Financial Disclosures (TCFD), Sustainability Accounting Standards Board (SASB), and the Global Reporting Initiative (GRI). Some governments are even seeking to make compliance with certain guidelines compulsory. This will only serve to further enhance the availability and quality of ESG data and improve the ability to extract value-add.

There are also increasing numbers of alliances – such as Climate Action 100+, the Net-Zero Asset Owner Alliance and the 30% Club – which are helping not only to improve reporting standards and data availability but to also help drive demand for ESG products. 

Of respondents who don’t factor ESG into their investment decision-making process, 50% said that they don’t think ESG is here to stay. But among those who do factor it in, 44% do so, at least in part, as a response to stakeholder pressure, and 11% don’t want to miss a trend. Client demand is driving a new era of responsible investing considerations and is shaping the direction of the investment landscape. Asset managers should heed their call and recognise this opportunity. Of the surveyed respondents, 82% viewed ESG considerations for RIHFs and QIHFs to be “not at all different”. From the largest institutional asset owner to the ordinary investor, there is increasing demand for ESG products, which would seem to indicate that, for now at least, ESG is here to stay. 

Another reason given for not factoring ESG into the investment decision-making process was that ESG investing is not seen to be within the scope of the fund. It could be that these investors don’t see hedge funds as being able to play a role in the ESG landscape. They may also believe that including ESG in their portfolios will limit their available investment universe through exclusions of high carbon assets, weapons or other types of holdings not typically associated with ESG. They may perceive long only investments to be better aligned with ESG strategies than their actively traded counterparts. 

The other side is that hedge funds have access to opportunities and tools that are not available to long-only funds. Where long-only mangers can only have divestment or engagement as an option to address company-level ESG concerns, hedge fund managers can take a short position and potentially profit if those concerns are not addressed and the share price falls. Short selling is newly emerging as an ESG strategy and there is still much debate about how and if it should be measured and incorporated within the ESG world. There is, nonetheless, certainly potential for shorting to become a mainstream approach to ESG investing. 

Financial materiality was both a reason for and against factoring ESG into the investment decision-making process among participants. All participants were asked if they agreed that ESG investing offers opportunities to generate alpha. The full spectrum from ‘strongly agree’ to ‘strongly disagree’ was selected, but there was a higher tilt towards some level of agreement. Furthermore, of our respondents who said ‘yes’ to integrating ESG into their investment decision-making process, 56% cited better returns and 67% cited risk management as part of their reasoning. Of those who said ‘no’, 50% said they don’t consider it to be financially material. 

Internationally, the alpha-generation opportunity is evident. ESG-compliant hedge funds in the Eurekahedge database outperformed their non-ESG counterparts in terms of annualised returns, and had returns of 10.59%, 10.03% and 7.5% over the last three-, five-, and 10-year periods, respectively. Further examples of hedge funds that have been able to successfully integrate ESG into their process include TCI, a value-driven hedge fund that has almost US$40 billion assets under management as of 2021, and HITE Hedge Asset Management in the US, which achieved 28% returns in 2020 with their long/short “carbon offset” fund in the same year that FFI Advisor’s Energy Transition long/short fund achieved 58% returns.   

Although there has been doubt regarding the financial materiality of ESG, the robustness and scope of studies demonstrating the effects of ESG on risk and performance have been improving over the years, with an increasing focus on isolating unique ESG factors as drivers of performance. This separation of variables proves that the positive relationships found are directly attributable to ESG. Studies undertaken by the Principles for Responsible Investment (PRI), Xponance, and MSCI, among others, all show demonstrable links between ESG scores and financial metrics, and returns. These links tend to be most clearly demonstrated over the long term and are stronger or weaker depending on factors such as geography and industry. South African investors should take note of the opportunities presented for emerging markets as a result of the strong correlations with ESG. 

Studies have shown that when ESG is separated out into the individual pillars of E, S and G, governance has the strongest mechanism for improving long- and short-term returns and mitigating risk. We asked our survey respondents if they felt one ESG pillar stood out to them as most relevant in the South African context; 55% said they were all equally relevant and 36% selected governance. 

ESG investing is not only about the financials; it also has ethics and values elements. Although not all respondents incorporate ESG, all stated that they consider ESG to be, at least to some degree, a part of fiduciary duty.

Frameworks such as the PRI, the Code for Responsible Investing South Africa (CRISA), and Regulation 28 all refer to ESG considerations in one way or another as part of fiduciary duty. With the core objective of the fiduciary being to act with loyalty and prudence in the best interest of the beneficiaries, exclusion of such matters would be in direct opposition to their responsibilities as fiduciaries. Despite this, the exact definition can vary across jurisdictions and as a result is still a topic of debate among investors, asset managers and policymakers alike. How hedge fund managers incorporate and interpret fiduciary duty is and will be a deciding factor in shaping the extent of ESG adoption within the hedge fund space – unanimity here is key. 

ESG investing within the South African hedge fund landscape is still in its formative years, and much could unfold in the future, especially with regards to the regulatory environment. Hedge fund managers may find themselves at a crossroads, having to choose between sticking with their traditional ideas or looking to a future where ethical and financial considerations coexist. Our survey revealed that for a small number of managers there is still reluctance to adopt ESG, but the majority view it as something that is extremely important to their investment processes and everyone – those who said ‘yes’ and those who said ‘no’ – sees it as part of their role as a fiduciary. Copyright. HedgeNews Africa – October 2022.

Susanna Yang, Chris Rezelman and Brooke Leaf-Wright are part of the RisCura Sustainability Team, helping to combine sustainability reporting with risk and performance, to provide clients with accurate reports that help them make informed decisions.