Research

The Hedge Fund ESG Experience: A Growing Conscience for Absolute Returns

Investors are increasingly beginning to incorporate ethical considerations into their investment decisions, a development which has given rise to the environmental, social, governance (ESG) framework over the years. Despite the implementation challenges which arise when screening investments against acceptable environmental, social and corporate governance themes, the trend towards a more conscientious approach to investment is here to stay, especially from the perspective of large institutional investors. Fund managers, for both actively and passively managed investment vehicles are balancing their quest for superior returns with the need to meet investor demand for responsible investing. Further, an understanding that such an approach to investment can translate into ‘ESG induced alpha’ for managers is further helping the cause of ethically guided investing. The piece below looks at the performance of funds, both long only absolute return vehicles and hedge funds, with an active ESG investment framework and how they have performed over the years.

The Eurekahedge ESG Fund Index, which tracks the performance of 33 fund managers1 that incorporate an ESG framework in their investment process is up 8.36% as of July 2017 year-to-date. This compares with returns of 12.61%, 7.10% and 7.93% for the MSCI ACWI ESG Leaders Index, the Eurekahedge Islamic Fund Equity Index2 and the custom Eurekahedge Equity ex ESG Fund Index3 respectively. Meanwhile the average global hedge fund has posted gains of 4.34% as of July 2017 year-to-date.

Figure 1 depicts the performance of the Eurekahedge ESG Fund Index versus comparable benchmarks since 2007. Over the period depicted, the Eurekahedge ESG Fund Index has posted annualised returns of 2.63%, ahead of Islamic Funds and the MSCI ESG Leaders Index which gained 1.84% and 2.37% respectively, while lagging the Equity ex ESG Fund Index which delivered 4.84% annualised returns. Fast forward these results by 12 months to begin post-global financial crisis of 2008, the Eurekahedge ESG Fund Index comes in tops with annualised gains of 9.41% since December 2008, while equity funds ex ESG framework trail by almost 60 basis points annualised.

Figure 1: ESG funds since December 2007
ESG funds since December 2007


Table 1 summarises the key performance statistics for the Eurekahedge ESG Fund Index relative to comparable benchmarks. Key takeaways include:

  1. The Eurekahedge ESG Fund Index compliant funds have outperformed comparable benchmarks depicted over each of the five, three and two year annualised periods, delivering annualised gains of 9.07%, 6.00% and 6.77% over these periods.
  2. Sharpe ratios (risk-adjusted returns) for the Eurekahedge ESG Fund Index compliant funds have exceeded the underlying market benchmark as depicted by the MSCI ACWI ESG Leaders Index over all periods depicted. To put this in perspective, with considerably lower annualised standard deviation of returns for ESG compliant funds, their Sharpe ratio over a five year annualised period comes in at 1.25 versus 0.81 for the MSCI ESG Leaders Index.
  3. The statement above holds true in comparison to Islamic Equity Funds as well with Sharpe Ratios exceptionally better over recent periods when the decline in oil prices has hurt Middle-Eastern economies and consequently the returns for Islamic funds with exposure underlying equity markets.
  4. Compared against the Eurekahedge Equity ex ESG Funds Index, the annualised standard deviation for ESG compliant funds has come in higher resulting in inferior risk adjusted returns over the five year period. However, the same does not hold true over the shorter three and two year time horizons whereby ESG compliant funds have fared better on Sharpe ratios.

Table 1: Eurekahedge ESG Fund Index vs. comparable benchmarks

Eurekahedge ESG Fund Index
MSCI ACWI ESG LEADERS Index
Eurekahedge Islamic Fund Equity Index
Eurekahedge Equity ex ESG Fund Index
2008
(40.74%)
(41.55%)
(39.79%)
(23.82%)
2009
34.51%
31.97%
(29.13%)
30.54%
2010
16.37%
10.43%
(12.36%)
12.54%
2011
(14.84%)
(8.41%)
(6.03%)
(7.58%)
2012
9.41%
12.41%
10.58%
10.34%
2013
17.22%
21.92%
(16.47%)
15.73%
2014
3.26%
2.80%
3.78%
3.78%
2015
2.34%
(4.15%)
(3.56%)
1.24%
2016
10.51%
5.54%
5.07
5.04%
July 2017 year-to-date
8.36%
12.61%
7.10%
7.93%
5 year annualised returns
9.07%
8.98%
6.46%
7.96%
5 year annualised volatility
6.44%
9.82%
7.63%
5.31%
5 year Sharpe Ratio (RFR = 1%)
1.25
0.81
0.72
1.31
3 year annualised returns
6.00%
4.04%
0.92%
4.71%
3 year annualised volatility
6.49%
10.47%
8.32%
5.64%
3 year Sharpe Ratio (RFR = 1%)
0.77
0.29
(0.01)
0.66
2 year annualised returns
6.77%
5.77%
2.68
4.88%
2 year annualised volatility
6.76%
11.54%
8.93%
6.22%
2 year Sharpe Ratio (RFR = 1%)
0.85
0.41
0.19
0.62

Source: Eurekahedge


Table 2: Correlation matrix (for returns since September 2007)
Correlation matrix (for returns since September 2007)

Figures 2a-2b offer important insights into understanding the return drivers for the Eurekahedge ESG Index. The first chart depicts the performance attribution for monthly returns based on regional mandate whilst the second chart accomplishes the same based on strategy.

With reference to Figure 2a, the constituents of the Eurekahedge ESG Funds Index are sorted based on their regional exposure into three buckets: developed markets focus, emerging markets focus or a global mandate that spans across both. As the chart reveals at a glance, emerging market mandated ESG funds feature heavily in the current index constituent base and have been the major factor influencing returns both on the upside as well as the downside. The implementation of ESG frameworks especially in marketing emerging market mandated funds to sophisticated overseas investors could potentially help add to the appeal for such funds especially in relation to themes such as sound corporate governance and social responsibility.

Figure 2a: ESG Funds Index: performance attribution by regional mandate
ESG Funds Index: performance attribution by regional mandate

With reference to Figure 2b, the constituents of the Eurekahedge ESG Funds Index are sorted based on their strategy into two main buckets: long only vehicles and hedge fund strategies. As is evident, long only strategies are key drivers of returns for the current constituents of the Eurekahedge ESG Fund Index, indicating the tilt towards emerging market mandated long only ESG compliant funds when viewed together with Figure 2a. This should help explain the comparatively higher annualised volatility and better returns posted by the Eurekahedge ESG Fund Index in relation to the Eurekahedge Equity ex ESG Fund Index. To further crystallise this point, almost 42% of the constituents for the Eurekahedge ESG Fund Index employ long only mandates, while the percentage drops to under 15% for the Eurekahedge Equity ex ESG Fund Index. In recent times where equity long bias strategies have done well, the concentration of long only mandates in an ESG Fund Index would bode well for the returns.

Figure 2b: ESG Funds Index: performance attribution by strategy
ESG Funds Index: performance attribution by strategy

The full article inclusive of all charts and tables is available in The Eurekahedge Report accessible to paying subscribers only.

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Footnote
1 Total 49 constituents include liquidated funds to adjust for survivorship bias.
2 Islamic funds can be viewed as a sub-=set of Socially Responsible Investment funds with slightly stricter ESG frameworks in some cases
3 A custom index composed of both hedged equity and long only fund strategies that excludes the constituents of the EH ESG Fund Index