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Green Hedge Funds?

ZoŽ Van Schyndel


Green Hedge Funds?
ZoŽ Van Schyndel, CFA
StarFish Financial Consulting Services

When organizations like CALPERS allocate money to hedge funds this is a signal that these funds are now so mainstream they are acceptable to most investors. Up to this point there have only been a few SRI hedge funds that have come to market. Green hedge funds can provide SRI investors with higher returns, particularly in negative market environments. Their use of short sales sends a very clear message to managementÖ.. Listen to us. Investors can no longer ignore the opportunities hedge funds present to encourage companies to meet social and environmental goals.

Hedge Fund Primer
Hedge funds are similar to mutual funds in the respect that they are both pooled investment vehicles. Individual investors buy into the funds and their investments are then combined. This commingling of assets allows the funds to use the buying power of many thereby achieving economies of scale that an individual cannot. Leverage or borrowing is an important component of these funds used to increase their returns.

Hedge funds are estimated to be a $700 billion industry growing at about 20% per year. There are now well over 6000 funds in the market. According to TASS Research hedge funds have already seen a net inflow of $20 billion so far this year surpassing 2002ís total of $16.3 billion.

Hedge funds do have some key differences from mutual funds. From the product side they are extremely versatile such that they can be adapted to virtually any customer risk/return objective. Importantly, there is no mandatory regulatory oversight of hedge funds in the US. The reduced regulations come with restrictions. These limitations are generally the number of participants in the fund; usually a 100 investor maximum, along with a requirement that the fund only accept financially sophisticated investors. Additionally the funds are limited in their marketing so that these activities are restricted to a one on one basis. Finally, the funds investments are constrained only by what they tell their customers they will invest in.

For a low fee investor the expenses that hedge funds rack up may be a little jarring. Hedge funds typically charge a fee of 1% plus 20% of the upside return on the fund. That may sound steep but will pay off if the fund performs well.

Most hedge funds are not Securities & Exchange Commission (SEC) registered so that information on a particular fund may be difficult to find. This could soon change. In September 2003 the SECís staff indicated they were interested in having hedge fund managers register with the agency as investment advisors. This would give the SEC the power to regularly inspect the funds. Managers would also have to disclose to their investors more information on their investments, and leverage amounts.

Investors that want to compare their funds return now have two options from mainstream index providers. Both Standard & Poorís and MSCI recently launched hedge fund indices. These indices are yet another sign of the growing visibility and importance of hedge funds. Of course hedge funds are an extremely diverse and fluid group so most indexes will not match exactly the investment style of your particular fund.

Due to the exclusivity of a hedge fund they have an appeal to a particular type of investor. These are limited offerings so the fact that you can participate while the huddled masses cannot intrigues certain individuals.

SRI Equity Hedge Funds

Currently there are only a handful of Socially Responsible Investor (SRI) equity hedge funds in the market ranging from those that are well established to new entrants. Green Cay Asset Management has four market neutral funds with approximately $200 million under management. These funds are managed using both social and environmental factors. A much smaller player is Winslow Hedge Fund with less than $20 million under management. This fund focuses on environmental factors and will go long or short depending upon the value of a particular stock. A Catholic and Islamic hedge fund of funds have each recently been created by Catholic Institutional Investors and Shariah Funds respectively. Unlike the Islamic fund the Catholic fund will be SEC registered.

Short Sales

Hedge funds often sell securities short in anticipation of buying them back in the future at a lower price. For most funds this strategy would be based upon an assessment of the securities or market overvaluation, or in anticipation of earnings disappointments. The strategy is also used as a hedge to offset long-only portfolios with the expectation of a bearish cycle.

Some SRI investors will say that they are long-term investors only so a short-term investment like a short sale is not one they are comfortable with. This investment approach is not for every investor.

Another concern is that short sale positions do not permit proxy voting so there is no direct management engagement. When the short position in their companyís stock rises to significant levels management will pay attention.

Selling stocks short entails risk if the market goes against you. Theoretically stocks have unlimited potential to rise in price. If you are caught on the wrong side of that price swing it could be extremely expensive. Of course there are strategies that can be utilized to offset this risk such as holding an offsetting put on the stock or only shorting stocks that you already hold a position in. Most investors holding stocks over the past few years would probably agree that being long can entail its own significant risk and potential for losses.

Once a SRI manager decides to incorporate short sales into their investment tool kit they then need to determine the strategy that they will take in this approach. Do you short only bad guys? If so then sell the stock of those companies that have poor financial, environmental, or social records. Should you short companies with good and bad financial, environmental, or social records basing your sales upon the stocks current valuation? Before going down the short sale road it is important to iron out these issues so that you and your investors are comfortable with whatever approach is taken.

Conclusion

SRI investors have traditionally questioned some of the investment strategies used by hedge funds to generate returns. In particular both the funds use of short sales as well as their trading focus limit hedge funds ability to engage management. These are points well worth considering.

Proxy voting is not the only mechanism open to get the attention of a company. If short sales work to reduce the stock price of a company that does not stand up to social or environmental standards is that a bad thing? At the same time if SRI investors utilize this approach to sharpen managementís attention to their concerns they may in fact end up engaging that very same management.
Why shouldnít we as SRI investors add another arrow to our quiver by utilizing short sales? Hedge funds offer SRI investors the opportunity to do well by investing in companies that have positive financials and strong environmental/social performance. Punishment falls directly on the shoulders of short sale candidates, those companies that have poor financial, environmental, or social records. Isnít this the best of all worlds?


ZoŽ Van Schyndel, CFA is the President and founder of StarFish Financial Consulting Services (StarFish), a US based organization providing consulting services to institutions.

StarFish Financial Consulting Services
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Email: zvanschyndel@email.com


 

 
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