The Disappointing Record of Socially Responsible Hedge Funds
New research shows that hedge funds that proclaim to adhere to socially responsible investment principles fail to follow through on that commitment and they deliver inferior performance results. The same is true of institutional funds in general, although the evidence is weaker.
Hedge funds collectively manage about $3 trillion and form an integral part of the portfolios of pension funds, sovereign wealth funds and university endowments, many of which have embraced socially responsible investing (SRI). For investment managers, a way to signal one’s commitment to responsible investment is to sign the United Nations Principles for Responsible Investment (PRI). Attesting to the spectacular growth in investor interest in responsible investment, assets under management of PRI signatories has grown from $6.5 trillion in 2006 to $86.3 trillion in 2019.
PRI signatories are expected to adhere to the following six principles:
- Incorporate environmental, social and governance (ESG) issues into investment analysis and decision-making processes.
- Be active owners and incorporate ESG issues into ownership policies and practices.
- Seek appropriate disclosure on ESG issues by the entities in which they invest.
- Promote acceptance and implementation of the principles within the investment industry.
- Work together to enhance effectiveness in implementing the principles.
- Report their activities and progress towards implementing the principles.
Does a commitment to SRI impact the performance of hedge funds? One possible answer is that firms that endorse responsible investment could enhance shareholder value by pressuring firms to improve ESG performance. Alternatively, by focusing on a smaller investment opportunity set that comprises stocks with strong ESG performance or that excludes sin stocks, PRI signatories may constrain their ability to deliver superior investment returns. Another important question is: Do hedge funds’ endorsement of PRI simply reflect efforts by money managers to exploit investors’ nonpecuniary preference for responsible investment?
Hao Liang, Lin Sun and Melvyn Teo contribute to the literature with their May 2020 study, “Socially Responsible Hedge Funds.” To understand what drives the performance of hedge funds managed by PRI signatories, they used the Thomson Reuters stock ESG scores to calculate value-weighted portfolio-level ESG scores for investment management firms. They evaluated hedge funds using monthly net-of-fee returns and assets under management data of live and dead hedge funds reported in the Hedge Fund Research (HFR) and Morningstar data sets covering the period 1994 through April 2019. Their fund universe had a total of 18,440 hedge funds, of which 3,896 were live funds and 14,544 were dead funds – demonstrating the importance of survivorship bias. It also demonstrates how high the death rate is of hedge funds. The authors also addressed the issue of incubation bias by dropping all returns data before funds were listed in the data sets.
Their data set included 2,321 PRI signatories. By the end of the sample period in April 2019, there were 174 PRI signatory hedge fund firms managing 489 hedge funds with $316 billion under management, an 11-fold increase in the hedge fund assets managed by PRI signatories. In addition, during this period the assets managed by hedge fund firms that endorsed the PRI increased from a modest 3% to 30% of all hedge fund assets.
The authors calculated firm ESG performance primarily using Thomson Reuters data. The Thomson Reuters ESG ratings measure a company’s relative ESG performance, commitment and effectiveness across 10 main themes: environmental resource use, environmental emissions, environmental product innovation, workforce, human rights, community, product responsibility, management, shareholders and corporate social responsibility (CSR) strategy. The ratings are derived from more than 400 company-level ESG metrics, which are based on information from annual reports, company websites, nonprofit organization websites, stock exchange filings, CSR reports and news sources. They complemented the Thomson Reuters ESG data with data from MSCI ESG Research (STATS) and Sustainalytics.
The MSCI ESG score is based on strength and concern ratings for seven qualitative issue areas, which include community, corporate governance, diversity, employee relations, environment, human rights and product, as well as concern ratings for six controversial business issue areas, namely, alcohol, gambling, firearms, military, nuclear power and tobacco.
The Sustainalytics ESG ratings gauge how well companies manage ESG issues related to their businesses and provide an assessment of firms’ ability to mitigate risks and capitalize on opportunities. Sustainalytics assesses a company’s ESG engagement along four dimensions: (1) preparedness – assessments of company management systems and policies designed to manage material ESG risks, (2) disclosure – assessments of whether company reporting meets international best practice standards and is transparent with respect to most material ESG issues, (3) quantitative performance – assessments of company ESG performance based on quantitative metrics such as carbon intensity, and (4) qualitative performance – assessments of company ESG performance based on the controversial incidents that the company is involved in. Following is a summary of their findings:
- Signatories exhibit better ESG performance than do nonsignatories; the average ESG scores for signatories and nonsignatories were 68.6 and 60.0, respectively. However, 21% of signatory ESG scores fell below the median ESG score – a significant number of signatories do not “walk the talk.”
- ESG scores are highly persistent – ESG performance is a durable characteristic of investment firms.
- Hedge funds managed by investment management firms that endorse the PRI underperformed those managed by other investment management firms by 2.45% per annum (t-statistic = 3.93) after adjusting for covariation with the Fung and Hsieh seven factors (bond, commodity and currency trend-following factors, equity and bond market factors, and equity and bond size spread factors). The spread in raw returns was 1.44% (t-stat = 2.06).
- The underperformance of signatory hedge funds is substantially stronger in signatories with low ESG scores – low-ESG signatory hedge funds underperformed low-ESG nonsignatory hedge funds by 7.72% per annum (t-statistic = 3.18) after adjusting for risk. In contrast, the difference in risk-adjusted performance between high-ESG signatory and nonsignatory hedge funds was a modest 0.54% per annum (t-statistic = 0.74).
- Hedge funds with low ESG exposure underperformed by a risk-adjusted 5.94% per year (t-statistic = 3.00) the hedge funds of those with high ESG exposure.
- The results were similar when decomposing the Thomson Reuters ESG score into the component based on environmental and social factors and the component based on corporate governance factors.
- The findings are not driven by smaller hedge funds.
- Signatories who do not “walk the talk” exhibit greater operational risk,
- While hedge funds that endorsed the PRI underperformed other hedge funds after adjusting for risk, they attracted larger flows and harvested greater fee revenues – signatories attracted an economically and statistically meaningful 16% more flows per annum than did nonsignatories.
Liang, Sun and Teo concluded: “The results suggest that some signatories strategically embrace responsible investment to pander to investor preferences.” They added: “The findings suggest that the underperformance of signatory hedge funds cannot be traced to high ESG stocks and, therefore, support the agency [risk, misalignment of interests] view.” They also noted: “Low-ESG signatories are more likely to disclose new regulatory actions as well as investment and severe violations on their Form ADVs, suggesting that they deviate from expected standards of business conduct or cut corners when it comes to compliance and record keeping.” Unfortunately, they also noted: “Investors appear unaware of the agency and operational issues percolating at such signatories. Low-ESG signatories attract as much fund flows as do high-ESG signatories.” The bottom line is that some firms appear to strategically endorse responsible investing but don’t walk the talk.
Their findings were consistent with those of Soohun Kim and Aaron Yoon, authors of the March 2020 study, “Analyzing Active Managers' Commitment to ESG: Evidence from United Nations Principles for Responsible Investment.” They found “a significant increase in fund flow to signatory funds regardless of their prior fund-level ESG score. However, signatories do not improve fund-level ESG score while exhibiting a decrease in return.” The decrease in returns was not related to decreasing economies of scale. They also found that only quant-driven and institution-only funds improve their ESG scores post signing: “Overall, only a small number of funds improve ESG while many others use the PRI status to attract capital without making notable changes to ESG.” And finally, they shockingly found that “signatories vote less on environmental issues and their stock holdings experience increased environment related controversies.” It is a shock, they added, because “environmental controversies have been documented to be tail risks that have significant negative implications to stock prices.”
Rajna Gibson, Simon Glossner, Philipp Krueger, Pedro Matos and Tom Steffen, authors of the May 2020 study, “Responsible Institutional Investing Around the World,” found similar results for U.S. domiciled institutional funds: U.S. institutions that publicly commit to responsible investing do not exhibit better ESG scores. However, non-U.S. institutions that publicly commit to PRI principles do exhibit higher ESG scores. Consistent with other research, they also found “weak evidence of lower equity portfolio returns when comparing them to non-PRI signatories.” However, they also found “evidence that negative screening, integration, and engagement lower portfolio risk.”
Unfortunately, the evidence demonstrates that at least a significant portion of funds use PRI as a marketing ploy and a way for companies to get free money. And for hedge funds, there is evidence that responsible investing has negatively impacted returns. The same is true for institutional funds in general, though the evidence of a negative impact on returns was weaker.
Larry Swedroe is the chief research officer for Buckingham Strategic Wealth and Buckingham Strategic Partners.
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