Hedge funds frustrated over lack of clear ESG regulations

The environmental, social and governance industry has grown to about a third of total global assets

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Hedge funds keen to get a piece of the $40 trillion environmental, social and governance (ESG) market are voicing growing frustration over what they say is an absence of clear regulations for one of their most popular investment strategies.

Companies including Man Group and BlueBay Asset Management say disclosure rules for environmental, social and governance investing still do nt explain how hedge funds should account for short selling.

As a result, many are now turning to their lawyers to help them avoid the kinds of legal risks that might arise if they mis-state their ESG positions.

“It’s becoming really problematic because of the fact that hedge funds don’t have frameworks or regulations to point to on this,” said Jason Mitchell, co-head of responsible investing at Man Group. “And by default, the ones that do exist, the regulations are essentially long-only friendly.”

The ESG industry has ballooned to make up about a third of total global assets, by some estimates, as financiers everywhere reallocate and rebrand much of what they do.

Much of that growth has taken place without many guardrails, and products such as ESG repos and derivatives remain for the most part unregulated.

Last year, the EU led the way in trying to rein in the ESG boom by enforcing an anti-greenwashing rulebook: the Sustainable Finance Disclosure Regulation. The EU says it covers all corners of the asset management industry, including short selling. SFDR also requires every firm targeting European clients, including those in the US and Asia, to abide by it. But hedge funds and their lawyers say the rules are not clear enough to let them operate with legal confidence.

“For long-only investors, SFDR is in some ways quite straightforward, but when it comes to hedge funds and alternative strategies, it’s much more difficult,” said Lucian Firth, an attorney at the London law offices of Simmons & Simmons.

“There are genuinely green strategies that involve shorting”, but “SFDR generally speaking doesn’t take into account short positions”, he said.

The industry is still awaiting clarification from the European Securities and Markets Authority (Esma) and the European Commission, Mr Firth said. The risk in the meantime is that the lack of clear rules will lead some hedge funds to stray on to the wrong side of the regulations.

“We’ve had some quite interesting conversations with frustrated managers who can’t believe it when we tell them that what they’re doing doesn’t fit in the regulation,” Mr Firth said.

A spokesperson for the EU Commission said that whether a hedge fund “intends to go short or long is irrelevant. What is relevant for SFDR is the ESG-sustainability related claims by products".

SFDR does not ignore short selling because the regulation “remains neutral in terms of design", said a spokesperson for Esma, Europe’s markets watchdog. It’s up to the hedge fund disclosing its ESG activities to “determine where its shorting activity, for example, is relevant for the disclosures”.

That said, hedge funds currently face limits around sustainability calculations when it comes to the use of derivatives, on which short positions can be based.

The European authorities developing the regulation’s reporting standards, known as RTS, say this is due to “an abundance of prudence”.

Adam Jacobs-Dean, global head of markets, governance and innovation at the Alternative Investment Management Association in London, says “there’s definitely not been sufficient focus” in SFDR in the role it plays “in terms of how firms do responsible investments".

We’ve had some quite interesting conversations with frustrated managers who can’t believe it when we tell them that what they’re doing doesn’t fit in the regulation
Lucian Firth, attorney at Simmons & Simmons

In the UK, where hedge funds play a more prominent role than in the EU, the Financial Conduct Authority is sorting through feedback on how its rulebook should address short selling, whereby an investor profits if an asset loses value.

“We recognise that a wide range of ESG strategies are currently observed in the market,” the FCA told Bloomberg. “These include a variety of alternative investment strategies, which may involve the use of traditional or bespoke derivatives to manage sustainability-related risks.”

Critics say there is an inherent conflict between short selling and sustainable investing. And even within the hedge fund industry, there is a debate about the extent to which shorting a fossil-fuel company, for example, actually reduces CO2 emissions.

The question is “whether you think you’ll have more impact”, My-Linh Ngo, BlueBay Asset Management’s head of ESG investment, said in an interview. “If you say to a company, I’m not going to invest in you because I think you’re really bad, you’ve got no seat at the table. Whereas if you go short, you have got a seat at the table.”

In the end, regulations look likely to determine how much ESG money flows into hedge funds.

Updated: March 19, 2022, 4:30 AM