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Governance: the foundation for ESG

CAIS blog series Governance: the foundation for ESG

Governance: the foundation for ESG

For investors driving environmental and social strategies, how can they ultimately be successful without governance?

Whilst there are a small percentage of hedge fund managers whose organizations are in the mature phase of the ESG implementation life-cycle, hedge fund managers can bring experience and expertise to the sustainability conversation. While hedge funds have been relatively slow when it comes to embracing the environmental and social aspects of ESG, they have long been at the forefront when it comes to governance issues. 

From interviews undertaken for the ‘Sustainable Investing: Fast Forwarding it Evolution’ report, most hedge fund managers demonstrated that governance considerations are firmly embedded in their investment process. There are managers who do not label these funds as ESG, however, use ESG factors for both inputs in valuation and risk management of their portfolio. Not all ESG concepts are new; previously before the ESG terminology, these factors were just known as “quality inputs”.  These have been embedded in the investment process for over a decade.

Demonstrated strong governance is an imperative for the investee company to achieve its long-term objectives.  Investors can gain confidence in the data being provided for their investment decision process and ongoing monitoring of the position. Where governance is not strong, this provides opportunities for hedge fund managers to actively engage with companies. 

ESG factors are typically used for generating alpha, targeting beta, identifying new opportunities or risk management, however it has not been proven that ESG strategies outperform and generate alpha and there remains skepticism in the industry; 71% of hedge fund managers and 75% of institutional investors are uncertain of the outcomes of their ESG-oriented investments [1].  

Conversely, Bloomberg recently reported that nine of the largest U.S. ESG mutual funds outperformed the Standard & Poor’s 500 index last year. Further, seven of those funds achieved greater returns than their market benchmarks in the past five years [2].

For investors driving environmental and social strategies, how can they ultimately be successful without governance?

There is not enough history of quality data to measure the outcomes of environmental and social investments, however the data on the impact of good governance has been around for a long time.  Where hedge funds have been active in shareholder engagement, there have been successes in changing management behavior and being able to generate alpha. 

There are differing shareholder perspectives and fiduciary responsibilities that need to be considered. The demands of trustees of pension funds, institutional investors, endowments and high net worth individuals will have competing time frames and ESG requirements.  For example, with the aging population pension funds will need to manage the balance between ESG investments and generating alpha to keep up with growing liabilities. Managers need to be able to balance these competing demands and as reliable data improves and there is a clearer evidence to be made for ESG factors in materiality, then such factors will be integrated further in the investment process.  

Governance is the most critical pillar of ESG in ensuring the successful balancing of short-term and long-term goals for both environmental and social outcomes, this ultimately drives valuation.   

by Ben Blair, Director


[1] KPMG-CIA-AIMA-CREATE survey 2020.