How Impact Investing Is a Win-Win for Hedge Funds

Deloitte offers five considerations for impact investing by hedge funds

Impact investing has been on the social finance scene for about a decade, but hedge funds have been slow to adopt the strategy, according to a new report from the Deloitte Center for Financial Services.

However, as hedge funds face performance challenges, they may be considering how this type of investing can support alpha generation as it will not only push hedge funds higher up the social spectrum, but also allow them to competitively differentiate themselves.

According to the report, impact investing can be defined as “the intentional allocation of capital to generate a positive social or environmental impact that can be—and is—measured.”

Impact investing, it says, blends the earlier concepts of investment screens and social selection criteria with the newer enhancements of intentionality and impact metrics.

At present, no hedge fund manager owns the impact investing space, giving early adopters a possible competitive advantage. The report notes that a growing class of investors wants to see these types of products within their suite of investment options.

For managers, this is about more than interest in a specific fund. It also opens opportunity to bring in new clients and deepen relationships with existing ones. Competition is fierce and any opportunity to show responsiveness to investor demands while being first in an untapped market is key, the report says.

It offers several considerations for managers taking a closer look at impact investing, and others already in the social space.

One. A lack of standardization for impact performance measures makes it difficult for investment managers to efficiently integrate impact measures into investment decision making.

The report says that as transparency around impact measurement and reporting increases, a growing evidence base of impact disclosure will help the market better evaluate impact investment as an investment strategy.

Two. Hedge fund managers have some hurdles to overcome before they actively engage in impact investing. Three are notable:

  • A portfolio manager’s intention toward the positive, whether social or environmental, sets impact investing apart from other strategies that may measure performance only after the fact
  • Another metric for success is that an investment needs to create measurable social impact, but for this investment, there may not be any additional value-add or impact beyond what previously existed
  • As the market matures, participating fund managers will want to differentiate their approaches around decision making and showcasing the value of the algorithms and trading/investing philosophies that support impact investment

Three. Investors will want to measure the performance of impact investing versus established benchmarks and weigh it against the opportunity cost of other investments not selected. The report points to a solution from Cambridge Associates and the Global Impact Investor Network, which jointly rolled out an impact investing benchmark in 2015 that assesses the performance of 51 private investments.

Initial results show that across all vintage years, funds in the Impact Investing Benchmark posted a 6.3% internal rate of return, versus the 8.6% returns of funds in the Comparative Universe. This suggests that achieving comparable performance may be a reasonable anticipation for impact investments, and hedge fund managers, though not represented in the benchmark, may find the results promising.

Four. Recent ERISA guidance may facilitate greater adoption of social strategies, including impact investments, according to the report. It notes that a 2015 Department of Labor bulletin clarified that plan fiduciaries may invest in socially oriented funds so long as the investment is “economically equivalent—with respect to return and risk to beneficiaries in the appropriate time horizon—to investments without such collateral benefits.”

Deloitte said that as the market matures, fund managers will be constrained to ensure that their investment strategies and disclosures continue to keep pace with the evolution in regulatory oversight.

Five. Demand for impact investments may not yet support launching a dedicated impact strategy, according to the report. Moreover, the hedge fund industry has recently faced market challenges that may negatively influence current traction for impact investing approaches.

But viewed more broadly, investor interest in ESG strategies is growing, which may translate into higher product demand in the future. The report notes that in mid-2016, 36% of hedge fund investors surveyed by Preqin “always considered” a fund manager’s environmental, social and governance policies when conducting due diligence.

As social awareness is generally trending in the marketplace, and with millennials showing high interest in impact investments while their influence rises as their assets grow, it may be merely a matter of time before demand increases.If this happens concurrently with managers achieving comparable financial returns using impact styles, the report says, a new and welcome type of demand challenge may emerge: finding the opportunity to deploy capital effectively.

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