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Environmental, Social and Governance (ESG) investing is gaining increasing investor interest and momentum – a 2020 OECD report shows that portfolios with ESG integrated elements exceeded USD17.5 trillion for that year. RisCura conducted an analysis to see how hedge funds are faring in this space.

Our analysis focused on the materials sector, including mining and resources, given that this sector is generally perceived to have negative ESG impacts. Mining companies, especially, are commonly accused of causing environmental damage and have a reputation of impacting communities negatively. They are therefore generally expected to score poorly with regards to ESG factors. But do they, in fact, score poorly?

From RisCura’s universe of hedge funds that we monitor, we took a sample of 27 funds (predominantly long/short) and looked at data between 31 March 2021 and 31 August 2021. Our sample showed that for March, an overwhelming 88% of these investments were long positions. In August, we observed a 2% increase in long positions (to 90%) and a corresponding 2% decrease in short positions. With the recent volatility in the materials sector and significant drawback in share price performance, managers may have viewed this as an opportunity to maintain their long bias or even top up. Considering the default perception that the materials sector scores poorly and our sample of hedge funds are still long biased, what is the ESG impact of their exposure?

To gain more insight, we carved out the materials sector, which makes up approximately 35% of the ALSI. Using the Global Industry Classification Standard (GICS), the sector is made up of 19 securities that are predominantly mining companies. We ran this underlying sample of stocks through a comprehensive quantitative ESG model by MSCI ESG Manager (where scoring ranges from the lowest score CCC to the highest AAA) to verify if, indeed, the materials sector scores poorly. Our analysis showed that this was not the case. Instead, this universe of materials has an overall ESG score of an AAA rating. At face value, this would suggest that our findings of hedge funds’ net long positions align with ESG risk screening and the goal of investing in companies with higher ESG ratings. Here, the materials sector appears to be doing well.

We investigated the reason for the AAA rating to determine why there is a difference between the perception and the reality. Through isolating the materials sector at an industry level within the entire MSCI universe, a trend among the companies in this sector became apparent. Most of the companies were poorly rated in terms of the Environmental and Social pillars but had very good G pillar ratings. MSCI ESG Manager looks at various key considerations when calculating the final score, so we looked at these key considerations within our sample carve out by decomposing the pillar scores.

The sector’s Environmental pillar, which considers factors such as toxic emissions and waste, biodiversity and land use, as well as water stress, had the highest weighting of 38% and is considered a laggard (rating between B-CCC). We also observed in our sample carve out that at a sector level, material companies were placed in the highest category of carbon risk. The sector’s S pillar, where considerations include, health and safety, labour management and community relations, is considered average and weighted at 29%. The sample carve out was also placed in the highest category of exposure to very severe controversies. The Governance pillar, where corporate governance and the corporate behaviour of a company are considered, has the second highest weight of 33% and is also considered average (A-BB). Although this pillar is average, at a sector level we found that more than 85% of the materials sector companies were considered governance leaders.

Despite the E pillar being a laggard, and the S and G pillars being average, our sample carve out has a leader rating (AAA). This is because the model accounts for how well these key considerations are being addressed and mitigated. Companies have protocols and initiatives in place to address the risks they face within each pillar and are rewarded for this in the scoring. These include engaging with communities, improving safety protocols, and decreasing carbon emissions. In fact, over the last quarter, 60% of the companies in our sample had upward revisions in their ESG Rating. This led to an improvement of the overall score to a AAA leader rating.

We are not forecasting what ESG frameworks for hedge funds will look like in the next few years (and there are several of them) and the extent to which ESG will be used as a risk mitigating tool within strategies. But we certainly try to look at the output from various ESG providers and combine it with our internal portfolio risk and performance data to better understand the data out there. Based on our sample of hedge funds, we see that the consistent exposure to the materials sector capital allocations from March 2021 to August 2021, does align with the upward ESG revisions of the sample carve out and the reality that the materials sector’s ESG scores are good, not poor.

Based on popular belief, the sample of our hedge funds managers’ long bias to the materials sector (predominantly mining stocks) should reflect a lower ESG score. However, RisCura’s analysis shows that the G component in these companies is seeing an upward trajectory and the bias is not as low in terms of ESG as one would believe. The positions our sample of hedge fund managers are maintaining in mining companies have very good governance, which translates not only to a good ESG score, but could also improve the E and S scores down the line.

More needs to be done to continue monitoring hedge funds and their allocation and ESG data within the materials sector over time to demystify industry perceptions and offer a different perspective.

– Nikita Hadskins and Susanna Yang 
ESG Analysts, RisCura