Can Alternatives go Green?

As ESG is becoming a mainstream investing strategy, alternative managers must produce answers. Can the mainstream coexist with the alternative? Liquid alternative funds are not only often complex animals, they are also a broad church. Some alternative strategies aim to preserve capital and invest in individual securities in a single asset class. Others seek high returns by taking high risks using derivatives and invest across the whole asset-class spectrum. Being so diverse, alternative strategies differ widely in how they integrate ESG factors into their investment processes.

Morningstar’s latest report Can Alternatives go Green? looks at how existing alternative funds include ESG considerations, looking at the menu of products currently available to European investors and how the different ESG approaches work in the alternative arena. We also examine the unique issues to consider.

“ESG integration is still in its infancy within liquid alternative strategies. We count only a small but growing number of funds with sustainability goals. However, with regulatory advancements continuing to evolve, and increased interest from investors, varying degrees of ESG integration are becoming more and more common. Alternative ESG funds remain largely a European phenomenon.”  

Francesco Paganelli CFA, Senior Manager Research Analyst, Morningstar

Key takeaways include:

• Of the over 1,400 European-domiciled alternative open-end funds and ETFs in the Morningstar Direct database, only 157 funds were Article 8. Overall, around 20% of the total assets under management in alternative funds were in Article 8 or 9 strategies. This is around half the share observed among equity, fixed-income, and allocation strategies. That said, Article 8 and 9 funds account for a much larger share of assets, illustrating investor preferences for such strategies.
• In contrast, only three alternative funds are classified as Article 9, showing how much more challenging it is to design an alternative investment product with a formal sustainable-investment objective and 100% sustainable investments (with the exception of cash and hedging instruments).
• For some alternative strategies, such as those relying heavily on derivatives, incorporating ESG factors can be complicated or even unfeasible. However, single-security strategies are adaptable to a range of ESG approaches, and this area is seeing a lot of product innovation.
• While some liquid alternative funds seem suited to manage financially relevant ESG risks, it’s generally more difficult for strategies in this space to adopt impact-oriented processes.
• There are five key areas that investors should watch out for when considering alternative strategies with an ESG layer: shorting, implementation, reporting, constraints, and timeframe.

Morningstar identified 31 funds that use ESG factors as a central part of their strategy. These funds tend to be small, the majority having less than EUR 100 million of assets under management. They’re also young, few being older than three years. Totaling around EUR 4.3 billion in size, they represent only 3% of the alternative broad category group’s asset base. By comparison, sustainable strategies account for about 20% of European open-ended fund and ETF assets within equity, allocation, and fixed income. Meanwhile, about one in five liquid alternative funds employs exclusions, citing, for example, international agreements such as the United Nations Global Compact.