Fintech Insights

In Light of Inconsistent ESG Regulations, Here’s Why the Hedge Fund Industry Is Turning to AI

Joe Holman | founder, ESG Administration LLC (ESGA) and Scott Alintoff | senior vice president and group executive for Product Management, FIS

September 28, 2021

The U.N. Principles for Responsible Investing and other efforts, such as the Carbon Disclosure Project, strive to encourage all stakeholders in the investment community to include environmental, social and governance (ESG) considerations in their buying and selling decisions. The European Commission’s Sustainable Finance Disclosure Regulation (SFDR), however, has now put teeth into it – at least in Europe.

When the legislation took effect in March of 2021, it established a level playing field for hedge funds and other financial market participants that present investment opportunities as sustainable. The mandate sets forth specific, standardized rules for how and what sustainability-related information must be disclosed on websites, in prospectuses and in periodic reports.

While the SFDR is likely to spur investment in European entities that can clearly demonstrate their positive impact on ESG issues, it’s possible the legislation may discourage the same in other countries. In the U.S., for example, the Securities and Exchange Commission is tightly involved, given its charge to protect investors, promote fairness in securities markets and share information to help investors make informed decisions.

Cautious steps

Unfortunately, the SEC is not expected to act any time soon for a variety of reasons. “Any decisions will affect all stakeholders, and there are many,” said Joe Holman, founder, ESG Administration LLC. “Because each has an individual set of objectives, it’s difficult to discern what they collectively want from companies attempting to position themselves in a favorable light, sustainably speaking.”

In addition, the commission always treads carefully before issuing rulings related to fast-evolving issues, because it doesn’t want to prematurely set a static list of disclosure requirements that might stymie engagement from the private sector and quickly become irrelevant. And clearly, the dust hasn’t settled on ESG investing.

Finally, there’s the gray area of materiality; that is, whether or not the information is important in deciding how to vote or make an investment decision. “Traditionally, investors have always made investments with the intent of making money,” said Scott Alintoff, senior vice president and group executive for Product Management, FIS. “Beyond that, it’s tough for the SEC – or anyone – to say if environmental, societal or other considerations also entered into a given decision. A company may be single-mindedly dedicated to cleaning up toxic waste, but if they’re exposing their workers to hazardous materials or indulging in bribery to achieve their noble mission, where do they stand on the ESG spectrum?”

If the U.S. Congress and the governments of other countries wanted to pass legislation such as the European Union’s SFDR, of course they could make that happen, but they would have to unite behind it. In the case of the U.S., that’s not likely to happen in the short term given the current environment.

Progress at the grass roots

In the meantime, investors are pushing their demands for sustainability using the power of the proxy. “It’s a slow process,” said Holman, “and it leaves a lot of room for companies to make big claims without backing up their words with action – a practice commonly referred to as greenwashing. But the truth will eventually come out on those that proclaim their sustainability but don’t practice it. The SEC is keeping its eyes out for offenders, one of whom will surely serve as an example.”

Hedge fund managers are working hard to break the code of what constitutes a sustainable investment offering and how to sift through vast amounts of ESG-related data to find them. With governments and regulatory bodies issuing guidelines and passing laws intended to bring discipline, the hedge fund industry is anything but business as usual. According to Alintoff, “Sophisticated tools that leverage the power of AI and machine learning technology are in development to simplify data management and integrate global ESG regulations into the entire investment life cycle.”