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Why it’s time for macro funds to take responsibility for ESG


Investing in line with Environmental, Social and Governance (ESG) principles makes perfect sense, in principle. 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 relentless growth in ESG investment strategies and sustainable finance markets signals a structural shift in finance.


Macro hedge funds, including Modular Asset Management, want to be – and must be – part of this transition. As well as wanting to reflect our own values and those of our investors, we recognise that ESG is already an important factor in shaping investment risks and opportunities.


A different challenge


But we as a macro manager face a different challenge than our hedge fund peers who mainly trade equities or credit. 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 reflect 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.


So our challenge sounds simple, but has complex implications: how do you assess the ESG credentials of sovereign instruments like government bonds, currencies or interest rate swaps?


Complicated questions


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 and to take action ourselves. In the absence of much quantitative data for our asset classes, we realise we will have to take a more qualitative approach. Like any innovation, this will be a process of iteration, though, and we won’t get everything right first time.


Integrating ESG considerations into the way we run our management company is fairly straightforward. It’s quite simple to track our carbon footprint and diversity, for example, and develop policies relating to these factors. But it’s much harder to integrate ESG in our investment portfolio, which is how we can have the greatest impact.


By its nature, applying ESG principles to an investment portfolio like ours throws up very nuanced questions. For example, our credit desk can – and does – choose not to take long risk positions in bonds from issuers engaged activities such as coal-fired electricity generation. If we were to apply the same exclusionary principle at the sovereign level, though, 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 faces challenges in adopting a normative approach to social factors such as gender equality in a region that spans frontier, emerging and developed markets as well as a broad spectrum of cultures and political systems. The United Nations’ Sustainable Development Goals provide a valuable set of aspirations, but how do we convert these into guidelines for making decisions about investments in government bonds and currencies? 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 on trying to apply ESG principles to our investment activity. 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 are starting by trying to understand 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.


To a great extent, Modular’s investment strategy is driven 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 – from sourcing minerals that make batteries for electric vehicles to building more sustainable infrastructure – are exerting an increasing influence over the allocation of capital in the region.


This is a natural consequence of policy moves towards achieving net-zero emissions by mid-century and the global growth in ESG assets under management, among other factors. In this environment, the link between ESG considerations and the spectrum of risks and opportunities for a macro investor in Asia is getting stronger all the time.


Proprietary framework


That is why we are developing a proprietary framework for assessing all the countries in which we are active from an ESG perspective. These internal sovereign ratings will be based on a selection of ESG-related factors that could impact those cross-border capital flows. Our proprietary assessment for each country will provide important context for our medium-term view on assets from 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.[1] Macro funds’ investment decisions do make a difference to sovereign and corporate bonds. Funds like Modular also pay significant fees to service providers that can be held to account for their ESG credentials.


When it comes to currencies, we expect that a growing pool of capital sensitive to ESG factors means these factors will exercise increasing influence over marginal capital flows. At Modular, we assess sovereigns through an ESG lens and use this analysis to inform a broader macro view on anticipated flows of direct and portfolio cross-border investment. As investors start buying or selling a currency because of these factors, we are sending an indirect signal to governments that amplifies the feedback they should be receiving from investors in their sovereign bonds.


Collaboration and convergence


As hedge funds seek to incorporate ESG factors into their investment approach, organisations like the United Nations Principles for Responsible Investment (UNPRI) and Alternative Investment Management Association (AIMA) are already marshalling consensus around the main priorities and providing guidance to market participants. This contribution to market development should continue to be well received by hedge funds, which are typically less well-resourced to develop their own ESG approaches than major long-only asset managers.


The reality is that macro hedge funds like Modular are in the early stages of a long journey towards the integration of ESG principles in our investment process. Over time, our approaches should start to converge, especially as ESG data-gathering improves and – potentially – some sovereign-level metrics start to become more widely accepted. At this point, though, it’s up to all of us to make a start. Modular is committed to doing just that.


We certainly don’t have all the answers, but we are serious about learning and determined to play our part in the development of ESG investment for hedge funds generally, and macro funds in particular. As our journey begins, we welcome feedback and ideas about how we – and the industry – can move forward.