Hedge funds should persevere and not be daunted by imperfections in ESG standards

INVESTING in line with environmental, social and governance (ESG) principles makes perfect sense. It should allow providers of capital to finance responsible and sustainable users of capital as well as generate returns from investment activities.

Many experts have recognised that the extraordinary growth of ESG investment strategies and sustainable finance markets signals a structural shift in finance.

'Macro' hedge fund managers, including Modular Asset Management, want to be - and must be - part of this transition.

This is entirely rational, as well as reflecting our values and those of our investors, because we recognise that ESG is already shaping our investment risks and opportunities.

But as a macro hedge fund that invests in instruments like government bonds, currencies and interest rate swaps, we face a different challenge than our hedge fund peers who mainly trade equities or corporate debt.

They have access to more established methods of applying ESG principles to portfolio management as well as an abundance of ESG data, relatively speaking.

And it's one thing applying an ESG lens to stocks or bonds from a single issuer, but another to apply them to instruments that represent a whole country. For a start, there is no commonly-accepted approach to doing this, nor even a consensus about what data should be used.

COMMON GROUND

We don't expect there will ever be a one-size-fits-all ESG approach for macro investors - and we believe that every investment firm should be accountable for meeting this challenge according to their own priorities, and those of their investors.

But we do think there is scope for more exchange on ESG within our industry, which should lead to more common ground. At Modular, we are determined to participate in that discussion, as well as to take action ourselves.

By its nature, applying ESG principles to an investment portfolio like ours throws up very nuanced questions. For example, we may choose not to invest in bonds issued by companies engaged in activities like coal-fired electricity generation.

But if we were to apply the same principle at the sovereign level, we wouldn't be able to trade the currencies or bonds of a single country in Asia: every major economy in the region still uses coal-fired electricity.

Similarly, a mainly sovereign-level investor like us faces challenges in adopting a normative approach to social factors such as gender equality in such a culturally and politically diverse region.

The United Nations' Sustainable Development Goals provides a valuable set of aspirations, and the UN Principles for Responsible Investment guide us at a high level on how to incorporate ESG into our investment practices, but how do we practically apply this guidance when making specific investment decisions about? What data would we use? And what - or whose - standards would we apply?

THE PERFECT AND THE GOOD

But the risk of an inconsistent or incomplete approach doesn't mean we should give up. We don't believe we should let the perfect be the enemy of the good, or at least the better. Our investors, our team and - ultimately - society here in Singapore and around the world expect nothing less.

So instead of being dismayed by the inherent difficulty of ESG investment for macro hedge fund managers and doing nothing, we want to take responsibility for our own progress and contribute to the development of ESG standards across the macro hedge fund industry. We started by understanding the areas where ESG factors intersect with our investment strategy, identifying where we can have the most leverage as an investor and focusing our efforts accordingly.

Modular's investment strategy is influenced by our views on how cross-border capital flows around the region will impact Asian currencies, interest rates and sovereign credit spreads. As we analyse these flows, it is clear that ESG factors are exerting an increasing influence over the allocation of capital in the region. That is why we have developed our own framework for assessing all the countries in which we are active from an ESG perspective. These internal sovereign ratings are based on a selection of ESG-related factors that could impact those cross-border capital flows. Our assessment for each country provides another important indicator that guides our medium-term macro view of that country.

As a hedge fund, Modular takes sometimes short-term views on the relationship between the performance of different instruments - unlike a traditional asset manager that buys instruments it expects to outperform and then holds them for the long-term. In this respect, we don't generally send direct signals about the cost of capital to issuers in the same way as our long-only colleagues.

That doesn't mean we don't have any influence, though. Globally, macro funds have estimated assets under management of US$190 billion, and the impact of this pool of capital on markets is amplified by leverage. So macro funds' investment decisions do make a difference to sovereign and corporate bonds. And hedge funds also exercise influence through the significant fees we pay to service providers, which can be held to account for their ESG credentials.

Macro hedge funds like Modular are in the early stages of a long journey towards the integration of ESG principles into our investment process. Over time, our approaches should start to converge, especially as ESG data-gathering improves and - potentially - some sovereign-level metrics are developed and start to become widely accepted. At this point, though, it's up to all of us to make a start.

• The writer is co-founder of Modular Asset Management