During the past decade, governments across the world have promulgated more than 500 new measures that seek to promote the use of environmental, social, and governance (ESG) criteria in making investment decisions. A comprehensive report from global public accounting and consulting firm KPMG International explores these three broad issues related to sustainable investing and its impact on the alternative investment industry: the rate of progress in implementing sustainable investing, the barriers to more rapid progress, and responses to these barriers.1
The KPMG report was produced in collaboration with CREATE-Research, “an independent research boutique specializing in strategic change and the newly emerging business models in global asset management.” Other participants were the Alternative Investment Management Association (AIMA) and the CAIA Association, which offers the Chartered Alternative Investment Analyst (CAIA) certification. A total of 135 investment managers and pension consultants from 13 countries in all key regions of the globe participated in this research project.
Progress and Obstacles
According to hedge fund managers surveyed for the study, institutional investors are by far the leaders in promoting ESG-driven investing. However, only 15% of these hedge fund managers “have embedded ESG factors across their strategies.” More widespread adoption is hindered by the fact that 63% of them find a “lack of robust templates, consistent definitions and reliable data.”2
Expectations and Outcomes
Among other institutional investors surveyed, 44% believe that ESG-oriented hedge funds can deliver enhanced alpha and reduce potentially large future risks, while 34% believe that adherence to ESG principles can have a material impact on the financial results of the companies in which they invest. On the other hand, 75% say that it is too early to tell whether sustainable investing indeed delivers superior returns, and 49% indicate that finding “consistent quality data” is a major hurdle to adoption.2
Indeed, 71% of hedge fund managers and 75% of other institutional investors reported that outcomes of their ESG-oriented investments have been uncertain. Moreover, among those other institutional investors, 14% indicate that the results have been negative.3
Early adopters of sustainable investing find that, because of excessive short-term focus, the markets have been slow to price in risks related to sustainability. On the other hand, they also indicate that advances in skills, data, and technology are helping to promote sustainable investing.2
Opportunities and Approaches
While many hedge fund managers see problems with the quality of ESG data as a hindrance to adopting sustainable investing, others see potential market inefficiencies that can be exploited to deliver alpha. Among respondents, 47% indicated that their organizations were skeptical about ESG data, 9% were overwhelmed, 19% were inquisitive, and 25% were opportunistic.4
Regarding how they use ESG criteria in making investment decisions, hedge fund managers cited several different approaches, the top three being integration (52%), negative screening (50%), and shareholder engagement (31%). Integration involves identifying key sustainability factors and using them in the decision process, often given equal weight to financial criteria. Negative screening excludes companies from consideration based on the “value system” of investors, and has been easy to implement. Shareholder engagement, wherein investors push corporate managements into adopting ESG principles, has been gaining “traction.”5
The report acknowledges that best practices regarding ESG-guided investing remain “a moving target.” However, the survey indicates that four “key enablers” will be necessary to speed up the process of ESG implementation. These are guarding against “greenwashing,” compliance with industry codes and principles, improving ESG reporting, and adopting Active Ownership 2.0.6
In this context, “greenwashing” is the process by which fund managers tout an ESG focus without having made a fundamental change in their investment processes. Among hedge fund managers responding to the survey, 41% see a significant amount of “greenwashing” in their industry, while 11% see some amount.
Regarding codes and principles, the UN Principles for Responsible Investing (PRI) have become a widely adopted standard among investment managers. Among the hedge fund managers responding to the survey, 35% are PRI signatories, and 17% are the process of becoming one. Meanwhile, 56% of managers are making PRI a key part of their cultures.
The “next frontier” for sustainable investing is measuring and reporting the non-financial impact of investments, the report notes. Currently, 57% of the hedge fund managers surveyed do not disclose performance with ESG metrics at all. Among the other institutional fund managers surveyed, 85% say that the hedge funds in which they invest do not offer any data at all on non-financial performance.
With respect to Active Ownership 2.0, the report indicates that 74% of the hedge fund managers surveyed rely on “shareholder engagement” to advance their ESG agendas. “However, except for high-profile proxy cases, end-investors do not as yet have a clear idea on what value is being generated by engagement activities due to a lack of fuller details,” the report adds.7
The Value Proposition
“Sustainable investing is about creating businesses of enduring value,” the report asserts. While sustainable investing is gaining acceptance in the capital markets, it nonetheless is a “slow process,” but with large institutional investors at the forefront.8