Hedging Bets: Can Hedge Funds Be Socially Responsible Investments?

ltcmA new discussion paper by the Principles for Responsible Investing Initiative seeks to apply the tenets of responsible investing to the high-flying world of hedge funds

In July, Robin Greenwood, an associate professor of business administration, and David Scharfstein, a professor of finance and banking, both at Harvard Business School, published a compelling research paper that examines the explosive growth of the financial services industry as fueled by the shadow banking system (i.e., short-term, loosely-regulated funding activities involved in the purchase of risky loans and securities). Entitled "The Growth of Modern Finance," the study aimed to assess whether or not the growth of active asset management has been beneficial to society. Their grim conclusion: "The shadow banking system that facilitated this expansion made the financial system more fragile."

They zeroed in on one element that has been a major factor in the financial industry's rapid expansion: the exorbitant fees accrued to alternative asset managers; i.e., those who manage venture capital funds, private equity funds and hedge funds. They calculated these fees to represent more than a third of the economic growth in the financial sector. Hedge fund fees, for example, peaked at $69 billion in 2007. That's more than the GDP of 120 countries, about $10 billion more than the GDP of Luxembourg.

Addressing this study last month in an article entitled "The Perils of Feeding a Bloated Industry," New York Times business columnist Gretchen Morgenson suggested, "It is worth remembering that the credit crisis and ensuing economic downturn followed a spectacular expansion in the financial business, compared with other industries."

PRI: WE NEED BETTER GOVERNANCE FOR HEDGE FUNDS

Indeed, hedge funds are big business. Estimates by Hedge Fund Research Indices (HFRI) show that hedge funds are a $2.1-trillion industry. And as we now know, they are also dangerous. But a newly released discussion paper aiming to spark an industry-wide dialogue on how the concept of responsible investment can apply to hedge funds may help this part of the financial sector address the fragility that Greenwood and Scharfstein have highlighted.

Published by the Principles of Responsible Investment (PRI) Initiative—a network of international investors working in partnership with the United Nations Environment Programme Finance Initiative (UNEP-FI) and the United Nations Global Compact—the paper, "Responsible Investment and Hedge Funds," is meant to help its asset owner signatories get a clearer understanding of hedge fund strategy risks while suggesting actions that investors should take to improve hedge fund governance. The authors note the timeliness of this discussion in the paper's executive summary: "A number of recent high profile incidents relating to hedge funds, including a few serious frauds, have caused governance to be raised to the top of the list of concerns for hedge fund investors."

“Many signatories have significant allocations to hedge funds and the PRI has a growing number of hedge fund manager signatories, said Rob Lake, Director of Responsible Investment at PRI. "However, there is currently no clear consensus on what being a responsible investor in hedge funds actually entails." A total of 137 PRI signatories have some exposure to investments in hedge funds (74 asset owners and 63 investment managers).

ARE RESPONSIBLE HEDGE FUNDS ACHIEVABLE?

The paper summarizes the responsible investment practices that hedge fund managers should implement, including: ensuring good governance, considering ESG research data before making investment decisions, managing benefits/risks associated with specific techniques like shorting, derivatives and high-frequency trading (HFT), managing benefits/risks that strategies might present to other parts of an investors' portfolio and maintaining clear communication —through a formal policy—between asset owners and investment managers.

A sample "Responsible Investment Commitments for a Hedge Fund" document, created by the PRI Hedge Funds Working Group, is also included in the paper as an appendix. The individual statements, 11 in all, certainly sound good on paper. ("We will consider environmental, public health, safety, and social issues associated with target companies when evaluating whether to invest" and "We will respect the human rights of those affected by our investment activities," are two examples.) But how many hedge fund firms will make such written commitments on a voluntary basis?

Paulus Ingram, chair of the PRI Hedge Funds Working Group and Senior Portfolio Manager Opportunity Fund and Hedge Funds at APG Asset Management, said that the discussion paper "highlights that responsible investment is achievable in hedge funds as it is in other asset classes." That may be true, but a lot of things are achievable. Whether or not the investment philosophy the paper espouses will actually become a reality remains to be seen.

ALIGNING OBJECTIVES: THE TRIPLE-BOTTOM LINE

To be sure, the PRI—though backed by the UN—embraces a very particular view on the notion of social responsibility, reflecting the fact that the principles themselves were drawn up not by a UN commitee or a group of policymakers, but by members of the international investment commnity: Investors must give due consideration to environmental, social and corporate governance (ESG) issues not necessarily because it is ethical or moral to do so, but because such issues have an impact on the performance of investment portfolios.

Who says your heart has to be in the so-called "right place" for you to engender a positive impact on society? For the PRI signatories, its about aligning individual objectives (e.g., make gobs of money) with those of society at large (e.g., do no harm, and maybe even some good). Ultimately, that alignment drives towards the so-called "triple bottom line" that has helped define the comtemporary sustainability movement: people, planet and profit.

In 2008, Richard C. Wilson, the founder of the Hedge Fund Group, a networking association for hedge fund professionals based in Portland, Oregon, predicted that socially responsible and green hedge funds would "explode in popularity in the next 5-7 years." There are still a few years to go before we know if his prediction will come true, but the PRI's new discussion paper suggests that socially responsible hedge funds are on the horizon.

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NOTES

Robin Greenwood and David Scharfstein. The Growth of Modern Finance. Harvard Business School. p. 31. July 2012. Accessed November 19, 2012.
Ibid., p. 9.
Gretchen Morgenson. The Perils of Feeding a Bloated Industry. The New York Times. October 27, 2012. Accessed November 19, 2012.
Hedge Fund Research. Hedge Fund Capital Inflows Steady Through Volatile 2Q12. July 29, 2012. Accessed November 19, 2012.
Principles of Responsible Investment. Responsible Investment and Hedge Funds: A discussion paper. p. 6. July 2012. Accessed November 19, 2012.
Hedgeweek.com. PRI launches discussion on responsible investment in hedge funds. November 12, 2012. Accessed November 19, 2012.
Ibid., 5, p. 6.
Ibid., p. 7.
Ibid., p. 22.
Ibid., 6.
Richard C. Wilson. Top 5 Hedge Fund Strategies. January 8, 2008. Accessed November 19, 2012.

image: The value of $1000 invested in the hedge fund Long-Term Capital Management, of $1,000 invested in the Dow Jones Industrial Average, and of $1,000 invested monthly in U.S. Treasuries at constant maturity. (credit: JayHenry, Wikimedia Commons)

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