An increasing number of institutional investors are requiring their hedge fund managers to incorporate environmental, social and governance (ESG) factors in their investment activities, says a new study. The report states that these investors now see ESG investing as serving their own long-term interests as much as those of wider society.

The study, Sustainable investing: fast forwarding its evolution, was published by KPMG, the Alternative Investment Management Association (AIMA), Chartered Alternative Investment Analyst Association (CAIA) and CREATE-Research.

"The traditional risk-return equation is being rewritten to include ESG factors," said Anthony Cowell, Head of Asset Management, KPMG in the Cayman Islands and co-author of the report. "In the hedge fund industry, ESG has gone from being a nice-to-have to a must-have."

ESG offers chances to generate alpha

The study involved 135 institutional investors, hedge fund managers and long-only managers with total assets of US $6.25 trillion in 13 countries. Some 45 per cent of these investors now base their investments in ESG-based hedge funds on the view that they offer opportunities to generate alpha, while also offering a more defensive portfolio that looks beyond the blind spots in markets that are slow to price in ESG risks.   

"Sustainability is set to reshape the ecosystem of capital markets and the behaviors of their participants. It requires mindset shifts from the way investing has been done historically," said Andrew Weir, KPMG Global Head of Asset Management, KPMG International, and a partner with KPMG China. "It will become the gold standard in investing."

Incorporating ESG in different ways

In the process, three avenues have been principally used by the surveyed hedge fund managers; incorporating ESG factors into the investment process (52 per cent), excluding securities that sit uncomfortably with the personal values of investors (50 per cent) and shareholder engagement (31 per cent). 

Currently, 29 per cent of hedge fund managers and 11 percent of institutional investors report positive outcomes. The scale of adoption and the outcomes so far have been hampered by the difficulties in creating a direct line of sight between ESG factors and their investment outcomes. 

On the upside, however, the resulting price anomalies offer opportunities to generate alpha for those who are progressing fast on the learning curve, says KPMG.  Markets usually price in progress only when it is in the rear-view mirror.