SRI and Hedge Funds – Any Chance for a Marriage?

Socially Responsible Investing – more than a fad?

Fads come and go. SRI might have looked like “flavor of the month” at the first “SRI in the Rockies” conference of 1990, but instead of disappearing, its popularity has increased year-on-year. For last year, the Eurosif (European Sustainable Investment Forum) Report put total SRI assets under management at around € 5 trillion (currently some US $ 7.11 trillion). This includes Core SRI with its positive selection of suitable investments, and Broad SRI with the opportunities that are left after negative screening of unsuitable ones. Any popular investment strategy merits investigation by hedge funds, whose operations are based on reallocating their AUM as returns from different investments vary over time. However, with divergences in investment approaches between hedge funds and SRI, the question so far has been whether they are compatible enough to work together.

It’s not just about money

The dual goals of SRI are to maximize returns while contributing to social well-being by factoring in non-financial criteria. Also described as sustainable or ethical investing, SRI typically champions human rights, social justice, ecological responsibility and corporate correctness. Different forms of SRI have existed for a long time. Refusals to invest in tobacco, arms and alcohol are just some of the historical examples. More recently, corporate greening and respect for the environment are issues that have gained attention. The growing realization by investors of the influence that they can wield on different organizations has led them to scrutinize both investment policies and investment vehicles, and to use that influence to change or boycott accordingly.

Where is SRI headed?

In a word – upwards. The figure for AUM for SRI continues to rise. With strong growth in European and American markets and a sizeable market potential in Asia, projections from organizations like Robeco and Booz & Company are for 25% annual growth and a 15% share of all Assets Under Management worldwide within the next 4 – 5 years. Whether or not the market segmentation remains the same however may be another matter. Today Core SRI is one-third of Broad SRI, the whole market being driven for the most part by institutional investors who hold 92% of the AUM for SRI. Bonds comprise 53% of total SRI assets, and equity just 33% (Eurosif figures for 2010).

SRI returns and performance

How does SRI compare with other investments? There is a temptation to consider SRI as an exercise in investor altruism, where performance is a secondary consideration and restriction in the investment universe leads to mediocre returns. Yet a 2007 study (by Leuven University) on the risk-return of Belgian SRI funds and a 2011 study on French SRI funds (by Capelle-Blancard and Monjon) showed neither underperformance nor over performance when compared to their non-SRI counterparts. Another study by Weber, Mansfeld and Schirrmann showed that a selection of 151 SRI funds performed better than the MSCI World Index between 2002 and 2009. Their conclusion suggests however that in-depth analysis and manager skill is still the most important determinant of performance. If there is any issue, it is that there is no standard approach to integrating SRI into portfolio management. Meanwhile SRI continues to demonstrate respectable returns and more.

A Hedge Fund/SRI stand-off

Pension funds, insurance companies and high net worth individuals are all contributing to the increasing demand for SRI. Hedge funds by comparison seem reticent. In Europe for example (Eurosif 2010), alternatives and hedge fund assets account for a modest 5.6% of total SRI assets. Hedge fund managers have perhaps viewed SRI so far as an eccentric offshoot of alternative investments, while investors have not yet found the alignment they want between hedge funds and SRI. Their problem is not only with the nature of the sectors in which hedge funds invest. It is also with some hedge fund strategy practices like selling short, which restricts possibilities to engage management in the corporations or sectors concerned. Less engagement means less influence and in turn less chance for SRI to achieve its parallel objectives of returns and social justice.

Opening the flood gates

SRI represents an increasingly important potential source of fresh capital for hedge funds. Conversely, if investors want to maximize their influence, hedge funds are a significant lever they cannot ignore. Trading sectors and trading practices may both need adjustment for the two to work together well. The argument for instance that short sales help SRI by reducing the stock price of companies that do not comply with social or environmental standards is short-sighted at best. SRI seeks to encourage compliant organizations, but not to deliberately damage the non-compliant. For instance, when the California Pension Fund withdrew from the Thai stock market in 2002, the Thai Stock Exchange created a SRI fund to protect the better employers from any negative impact.

SRI has also shown itself to be buoyant in the recent global financial woes, growing by 13% in the US between 2007 and 2010 compared to just 1% for other professionally managed assets. SRI has the potential to provide hedge funds a useful diversification of their portfolios and their investor base. In the same way that industrial corporations have often found that going green turns out to be advantageous not only environmentally but also economically, hedge funds may well find that going “SRI” not only satisfies investor demand for social justice, but brings direct financial benefits as well.

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