This report is a joint effort, involving KPMG International, CREATE-Research, AIMA and CAIA. It examines in detail sustainable investing and its impact on the alternative investment industry, and how sustainable investing is gathering momentum across the investment universe.

Over the past decade, various governments worldwide have enacted over 500 new measures to promote environmental, social and governance (ESG) issues. While various players have been involved (governments, regulators, capital markets, businesses and consumers), this report focuses on capital markets in general, and particularly sustainable investing —  which is described in this report as an evolutionary investment journey, underpinned by three overarching stages known as ‘ABC’: (A) avoid harm and mitigate ESG risks; (B) benefit all stakeholders; and (C) contribute solutions to societal problems.

Given the magnitude of efforts which sustainable investing seeks to address, it’s no surprise that various actors have come together to seek to address these issues. Among the diverse actors which this report highlights, are hedge funds and institutional investors, who have played an important role in the early adoption and advocation of sustainable investing.

This report focuses generally on capital markets and explores three issues:

• The current state of progress in implementing sustainable investing 
• Constraints on the pace of progress
• How those constraints are addressed by evolving best practice 

Two additional caveats should be noted. Firstly, the geographical coverage is primarily North America and Europe, followed by a secondary focus on Asia Pacific. Secondly, the respondents are hedge fund managers and their institutional clients, and early adopters, which constitute C-suite executives from a sample of large institutional investors, a global hedge fund, and long-only asset managers who collectively manage over US$4.6 trillion of assets.

The findings of this report fall under two main sections:

• The rise of ESG in the hedge fund industry 
• The rise of sustainable investing.

Current state of progress

Institutional investors are driving the ESG agenda. For their part, hedge fund managers are well placed to respond on account of their deep talent pool, technological capabilities, nimble investment strategies and activism track record. Their short-selling expertise has always been valued in encouraging their investee companies to up their ESG game. The report finds that hedge fund managers are deploying ESG factors to target three goals – alpha returns, beta returns and risk management.

Constraints on the pace of progress

A number of factors have conspired against progress thus far. Far and away the most important one is the lack of quality and consistent data on ESG factors. Another notable one has been confusion over industry terminology.

Evolving best practice

Best practice in the ESG space is a moving target. It’s no longer enough for a hedge fund manager to rely on exclusion screens. Increasingly, there is an expectation that investments should generate a positive (and measurable) ESG impact, while managing the inherent risks. To fast-forward the ESG implementation cycle, the report identifies four key enablers:

• Guard against greenwashing
• Comply with industry codes and principles
• Improve ESG reporting
• Adopt active ownership

1. Fettered progress: Institutional investors are the biggest drivers of demand for ESG-oriented hedge funds (85%), yet only about 15% of hedge fund managers have embedded ESG factors across their strategies. Progress has been curbed by inadequate templates, inconsistent definitions and unreliable data.
2. A case of the 'boiling frog' effect: 55% of ESG-oriented hedge funds have implemented strategies which have targeted alpha, while managing fat-tailed far-off risks. Markets have evidently been slow to price in sustainability risks due to their excessive focus on short-termism.
3. An imminent face-off: Despite the slow adoption of ESG factors into their strategies, hedge fund managers are now facing nascent challenges due to the growing pressure from ESG-oriented investors and indirect stakeholders to adopt sustainable investing best practices.
4. The emergence of a new infrastructure of skills, data and technology is creating tailwinds for sustainable investing. This, however, faces a major barrier as there are generally no agreed-upon guidelines for what constitutes a ‘good’ or ‘bad’ company. This has resulted in fragmented approaches to sustainable investing—or worse, the practice of greenwashing (as asset managers repurpose their old funds with sustainability labels) or whitewashing (as investee companies overstate their green credentials). Both are widespread in developed markets.
5. Top 5 investor expectations: A robust policy on responsible investment; relevant investment talent and accountability that goes beyond compliance/legal staff; a screening policy; firm engagement with investee companies; reports on the outcomes of those engagements; and internal controls to ensure its responsible investment policy is enacted.
6. Institutional investors do not only want their hedge fund managers to screen out ‘sin stocks’, but they also want them to target positive ESG outcomes in tandem with alpha generation. Thus, the traditional risk-return equation is being written to include ESG factors.
7. For their part, hedge fund managers are well placed to respond on account of their deep talent pool, technological capabilities, nimble investment strategies and activism track records. Their short-selling expertise has always been valued in encouraging their investee companies to up their ESG game.
8. Hedge fund managers are deploying ESG factors to target three goals – alpha returns, beta returns, and risk management.