One way or the other, it’s clear that the investment industry will play an important role in enabling this transition, and, in truth, it already has through institutional and individual environmental investment preferences and broader funding. There is absolutely no way governments can fund and enable this transition on their own. That said, what should be top of mind for the stewards of private capital―securities and investment firms―now that the COP28 conference is over?  

Net-Zero Commitments and Investor Alignment  

Although many investment firms have done so already, there will likely be an increase in the number of firms announcing net-zero commitments and how they plan to align their portfolios to meet those commitments. Globally investment decisions will be influenced by country specific requirements. Retail investment products such as net-zero aligned target date funds or services that help investors align their investments to meet certain goals may gain traction as well. However, with an election coming up in less than one year, ESG markets and frameworks will become even more deeply embroiled in the U.S. culture wars, with significant implications for both American institutional asset managers and wealth managers regarding which way client appetites tilt.  

Carbon Credit Markets  

As the agreement reached at COP28 allows for carbon capture as an engine to lower overall emissions, the markets in which carbon credits or offsets trade are likely to expand. This will play an important role in how firms lower the emissions associated with their investments as well as hedge against unforeseen emission increases. Although seen by some as a controversial way to reduce emissions, carbon credits are expected to play an important role in allowing for overall emission reduction while the global economy slowly transitions away from fossil fuels. For the moment, there is an embryonic retail market for private individuals to invest in carbon markets, mainly through certain mutual funds and ETFs, green companies, and carbon credits. While this market absolutely needs to grow exponentially to meet climate change targets, securities and investment firms will again need to navigate highly polarizing political forces that ultimately shape clients’ investment rationale.  

Embrace Technology  

Advanced technology such as AI and machine learning will be necessary tools for investment firms to fulfill their role in the larger global transition to a greener economy. AI can collect and help analyze vast amounts of data and information as well as estimate metrics for the data that doesn’t yet exist such as Scope 3 GHG emissions or emissions for smaller companies that aren’t able or required to measure and disclose it themselves. AI will also help investment firms disclose the necessary information required by the onslaught of ESG and climate-related regulation coming into play around the globe.  

It’s Not Enough to Just Have the Data, You Have to Know What to Do With It 

In recent years, investment firms have continued to shell out large amounts of money on ESG data and ratings without always really knowing if they could trust it and how to normalize that data in the absence of standards. As the quality and availability of the data has improved, many firms with the financial and human resources to do so have also spent the time building up their in-house capabilities. The reality is most firms lack the resources to do so and find the easiest and sometimes cheaper option is to outsource processes to third parties, such as ESG data management, data collection, and reporting. Either way, this is something they will need to consider soon, even if they aren’t an ESG-focused firm. Datos Insights is paying close attention to vendors that offer impact reporting to help investors tangibly align their portfolios with their values while mitigating the potential for greenwashing. 

Conclusion 

As we enter 2024, it is clear there will be an ongoing focus on the “E” in ESG. Financial institutions need to keep tabs on and understand the emerging models, risks, and opportunities associated with COP28 goals. Firms across the capital markets and wealth management spectrum will need to consider where, when and how the evolution of the regulatory, social, and political landscape will impact their businesses. If you’d like to discuss these key findings and other important future implications, please contact Adler Smith for capital markets or Wally Okby for wealth management.

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The EU’s Sustainable Finance Disclosure Regulation (SFDR) lays out three categories for investment funds to identify with:

• Article 6 funds either do not integrate ESG or sustainability considerations into the investment process and explain why they are not relevant, or they do integrate them broadly but do not meet the criteria for Article 8 or 9.
• Article 8 funds promote environmental and/or social characteristics, among other characteristics, and the companies invested in have good governance practices.
• Article 9 funds have sustainable investment as their core objective.

Despite challenging economic times marked by inflationary pressures, rising interest rates, a potential global recession, and geopolitical risks from Russia’s war with Ukraine, European investors continued to pour 12.6 billion euros into funds classified as Article 9 under the EU SFDR in Q3 2022 while bleeding 28.7 billion euros from Article 8 funds over the same period, according to data from Morningstar.

Looking back longer term, all European funds classified under SFDR experienced net inflows in the last three quarters of 2021. However, the nebulous nature of Article 8 and ongoing concerns in the industry around greenwashing appear to be driving European investors toward products that have a more clearly defined investment objective or strategy as it relates to sustainable investing.  

Many have criticized the SFDR for its lack of clarity around Article 8 in particular, complaining that the range of funds that could claim Article 8 classification is much too wide and that it isn’t helping with the proliferation of greenwashing.

In fact, 64% of capital markets firms responding to Aite-Novarica Group’s 2022 ESG Survey indicated that they believe greenwashing is widespread in the investment industry, with only 5% of respondents disagreeing with the assertion. Additionally, nearly three-quarters of respondents (74%) in the same survey agreed that SFDR guidelines should be more explicit regarding what funds can be classified under Article 8.

Despite the flow movements, the latest numbers highlight that more than half (62.6%) of funds in Europe classified under SFDR were still non-ESG-affiliated products, or Article 6, while a third (33.6%) were Article 8, and the remaining 4.3% were Article 9. Morningstar’s data also showed that European asset managers reclassified the status of 383 funds under SFDR in the third quarter, 342 of which represented upgrades, with the vast majority (315) from Article 6 to Article 8. And although investors are flocking to dark green funds, managers downgraded 41 funds to Article 8 from Article 9 in that same quarter, likely due in part to the increased scrutiny and additional disclosure requirements that accompany an Article 9 classification.    

As ESG fund regulations shift, products will continue to evolve, but overall they should allow true impact funds and those with clear sustainable objectives to stand out to investors seeking such vehicles. To learn more about developments in this space, as well as the impact other fund regulations like the SFDR will have on the investment management industry at large, read my colleague Paul Sinthunont’s and my latest report ESG Fund Regulation: Greenwashing Under the Microscope or contact me at asmith@datos-insights.com. 

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Last year’s performance was truly nonlinear, punctuated by disparate returns across strategies. Managing those funds also became more complicated. Remote work, meme stocks, and volume spikes from individual investors added to the complexities of optimizing liquidity. With the Barclays Hedge Fund Index down 9.58% through the end of June, 2022 has been another challenging year. 

With that as background, how are hedge funds looking at electronic trading and the algorithmic trading providers who support them? A few insights from this year’s Algorithmic Trading Survey: Hedge Fund 2022 conducted by The TRADE offer good perspective. 

How Algorithm Usage Is Changing

Hedge funds largely rate their providers on par with 2021 as the average score of 2022 respondents declined slightly—from 5.82 in 2021 to 5.80. This is not so far off 2020’s average of 5.77. Either provider offerings are not improving or, more likely, traders’ expectations are increasing.

Most categories received lower ratings this year compared to last, but the range of average scores continued to tighten in 2022. Although there is still room for improvement, this indicates further convergence of provider services and less differentiation across the top providers.

Here are a few of the key takeaways Aite-Novarica Group saw in this year’s survey:

• Execution quality remains top of mind, with hedge funds desiring additional features including further customization capabilities, more control, deeper dark aggregation, and increased reduction of market impact.
• Hedge funds reported that the most impactful factor in choosing algorithmic providers is customer support, followed by ease of use, execution consistency, increased trader productivity, and dark pool access.
• The top four reasons hedge funds use algorithms are ease of use, to reduce market impact, to increase trader productivity, and consistency of execution performance.
• Hedge funds of all sizes (except those with more than US$50 billion under management, who are typically also managing traditional assets) on average increased the number of algo providers they use. Hedge funds with US$1 billion-$50 billion under management reported using more than five algo providers on average, more than respondents at firms of other sizes.
• Hedge funds increased their use of every type of algorithm, with dark-liquidity-seeking algos the most frequently used.

What Lies Ahead?

Providers are focused on delivering against the highest priorities of the market. The increase in electronic trading and automated trading for asset classes outside of equities will grow in the coming year(s) as a result of a variety of factors and market evolution. These factors include growth in non-equity index products or basket products like actively managed fixed income ETFs, fixed income portfolio trading, as well as interest rate volatility fueling the growth of the FX market. The increase in new liquidity-accessing options will then present a value proposition for firms looking to access those liquidity venues efficiently. 

However, whether this will lead to hedge funds looking for asset-class-specific providers and subsequently growing their average number of providers used or instead diversifying the types of algos and automated trading solutions used by asset class and strategy and holding the number of providers relatively constant remains to be seen.

Providers have generally improved their offerings over the years, and there have been efforts on both sides to consolidate relationships, but at the same time there remains a desire for firms to diversify vendor exposure and capabilities, leading funds to engage in additional provider relationships.

This blog post was adapted from the full analysis of The TRADE‘s Algorithmic Trading Survey: Hedge Fund 2022. You can read the full survey here. To discuss this topic further, please reach out to me at asmith@datos-insights.com.

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