Already, we are at risk of ESG fatigue. We are bombarded on social media with news of ESG conferences, ESG-related services, ESG ‘experts’ and empirical research validating ESG policies. The noise is reaching a feverish pitch and we are at risk of switching off before this aspect of the investment management industry even gets going. In recent times, ESG has undergone a dramatic makeover from being regarded as a whacky, but well-intentioned, means of reducing profits, to a must-have policy that has the potential to enhance profits.
The adoption of ESG policies as an overlay to an existing investment portfolio has moved from “whether?” to “how?” in a short space of time. Faced with off-the-shelf solutions and so-called experts, investment managers must look through the noise and be alive to the risks involved, which are too often going unrecognised.
Ten-point plan to facilitate transition to an ESG policy:
(1) Risk Assessment: The risk assessment undertaken by investment managers in connection with the adoption of an ESG policy is often limited to measuring anticipated change to performance and value-at-risk. This is necessary and vital, but the risk assessment must extend beyond the portfolio manager and include operations, investor relations, compliance, legal and treasury. The implementation costs, impact on liquidity, portfolio composition, average holding periods and operational adjustments are just some of the areas that must be considered.
(2) Legal Framework: ESG does not exist in a vacuum. This arena is framed by a host of laws and regulations that extend far beyond the usual legal and regulatory considerations for investment managers. ESG and sustainable finance-related EU rules mark only the beginning of the analysis. Other laws that may impact the construction and implementation of ESG policies include anti-boycott legislation, which may have extra-territorial reach by virtue of the investor base. Engagement policies in response to new stewardship rules also require consideration. Stewardship is not a byword for ESG, but there is some overlap.
(3) Product-specific Policies: Often ESG policies will prohibit long positions in specific stocks. However, the fund will likely have different degrees of exposure to certain stocks, including short positions, derivatives and long positions where the hedge fund has no direct relationship with the issuer. The ESG policy should specifically cater for these positions as well. The ESG policies of a pension fund investing in a hedge fund will often, therefore, not be readily transferable to a hedge fund’s strategy. For example, what should be the hedge fund’s policy where a non-compliant position is a constituent part of a basket referenced in a swap? What if the offending position is part of a paired arbitrage trade? What if it is hedging out risk in the portfolio? What if the position is de minimis? What if the position was not bargained for but is the result of a takeover? All of these questions are nuanced and should be considered in advance.
(4) Transition Policies: For the majority of hedge funds, an ESG policy is an add-on to an existing portfolio; they are not building an investment portfolio from scratch. Put simply, the former requires specific dis-investment policies; the latter is more focussed on exclusion policies. The transition policies should ensure that the necessary changes can be effected in ways that are not disruptive or costly, but are in the best interests of the fund. Typically, this will not involve implementation of an ESG policy overnight, but over a period of time, giving the investment manager discretion as to unwind timing and scope to maintain ostensibly non-compliant positions on certain exceptional grounds.
(5) Adequate Disclosure: Hedge funds are required to make adequate disclosure of the risks to enable prospective investors to make informed decisions. Investment managers should therefore consider whether the adoption of an ESG policy requires corrections or updates to its offering documents. Investment managers should also consider whether the overlay of an ESG policy to an existing portfolio is material enough that existing investors should be informed and offered a redemption right.
(6) The Board: The board’s role should not be passive here. To assume that these changes are within the investment manager’s pre-existing mandate may be misguided. The adoption of an ESG policy is not a routine investment management decision, but potentially a departure from the course of dealing previously established. The Board should fully understand the risks involved and be afforded the opportunity to ask questions of the investment manager before the policy is approved. The board may want to ask how a specific investor’s ESG requests are accommodated, such as whether these can be incorporated into the overall strategy and if not, whether the investor would be content with an accounting adjustment to exclude P&L from non-compliant positions through a separate share class or whether the investor should be housed in a separate managed account.
(7) Service Providers: Many service providers, including depositories and administrators, now offer “ESG services”. It is vital that an investment manager understands whether what is offered is adequate and best suited to its needs. Simply adopting an exclusion list as the means of implementing a policy, just because an external provider offers cross-checking services, allows the tail to wag the dog. The binary nature of negative screening, for example, may not be appropriate having regard to the nature of the policy, investment portfolio and the strategy. Shorting “bad” names instead might be an alternative in some strategies. Investment managers must consider how best to implement a policy and, in all circumstances, be alive to the risk of fettering their discretion when outcomes are pre-determined. To date, prime brokers, who provide post-trade facilities, have had little involvement in this area. However, there is likely to be an increasing role, and opportunity, for prime brokers not only in terms of facilitating voting and issuer engagement, but also in providing exception reporting for non-compliant positions. It will also be interesting to see whether prime brokers contribute to the global move towards ESG investing by aligning their risk-based margin calculations and margin release levels to reflect perceived quality of stocks based on reputable ESG indices.
(8) Reputation Management: It is often assumed by investment managers that the adoption of an ESG policy is PR-positive. The exclusion of (for example) tobacco or pay-day lending stocks are often demanded by specific investors and regarded as uncontroversial by other investors in the fund. However, where the investment manager implements an exclusion or dis-investment policy of a specific investor (in return for a significant investment of capital), the investment manager should consider the issues and risks it then faces. An investor’s demand may be discriminatory, inconsistently applied across countries, regions or sectors, be based on biased data, a political agenda or the underlying facts or law may be in dispute. The investor is entitled to consider its own interests to the exclusion of other investors in the fund, but the investment manager cannot adopt the same stance. It must consider what is in the interest of the fund as a whole and adopt a policy that is rigorous enough to weed out these issues.
(9) Pre- and Post- Trade Policies: The ESG policies should address not simply how an investment decision is made but how to manage the consequences of a breach of the policies, such as the acquisition of a non-compliant position or failure to dis-invest of a non-compliant position. Such post-trade policies are often expressed in qualitative and quantitative terms. For example, where applicable laws permit, investment managers may consider the scope for a de minimis or other permitted margin of error. They may also wish to ensure that there is some investment manager discretion allowed when it comes to unwinding positions, to ensure that the timing suits the fund and/or that there is a suitable alternative investment available, particularly in a low interest environment.
(10) Status of the Policy: Investment managers ought to consider what status to afford the ESG policy. Should it be elevated to the status of mandatory investment parameters, where the consequences of breach are covered by the investment management agreement, or should it have some lesser status? This may depend on various dynamics, including investor expectations and the nature of the portfolio, but this is a question that must be addressed at the outset of the policy.