(Bloomberg) — Hedge funds eager to capture a slice of the $40 trillion ESG market are expressing growing frustration at what they say is no clear regulation for one of their most popular investment strategies.

Companies such as Man Group Plc and BlueBay Asset Management LLP say the disclosure rules for environmental, social and governance investments still fail to explain how hedge funds should account for short selling. As a result, many are now turning to their attorneys to help them avoid the kind of legal risks that could arise from misrepresenting their ESG positions.

“It becomes really problematic due to the fact that hedge funds don’t have frameworks or regulations to point this out,” Jason Mitchell, co-head of responsible investment at Man Group, said in an interview. “And by default, the ones that do exist, the rules are essentially only long friendly.”

By some estimates, the ESG industry has exploded, making up about a third of total global wealth by some estimates, as financiers around the world reallocate and rebrand much of what they do. Much of that growth has happened without many guardrails, and products like ESG repos and derivatives remain largely unregulated.

Last year, the European Union tried to curb the ESG boom by imposing an anti-greenwashing rulebook: the Sustainable Finance Disclosure Regulation. The EU says it covers all corners of the wealth management industry – including short selling – and requires any company targeting European clients to adhere to it. But hedge funds and their lawyers say the rules aren’t clear enough to allow them to operate with legal confidence.

“For long-only investors, SFDR is pretty simple in some ways, but when it comes to hedge funds and alternative strategies, it’s much more difficult,” said Lucian Firth, a lawyer with the London-based law firm of Simmons & Simmons LLP. in an interview. “There are really green strategies that use shorting,” but “SFDR generally doesn’t take short positions into account,” he said.

The sector is still awaiting clarification from the European Securities and Markets Authority (ESMA) and the European Commission, Firth said. The risk in the meantime is that the lack of clear rules will lead some hedge funds to end up on the wrong side of the regulation.

“We’ve had some pretty interesting conversations with frustrated executives who can’t believe it when we tell them what they’re doing isn’t compliant,” Firth said.

A spokesman for the European Commission said whether a hedge fund “intends to go short or long is irrelevant. What is relevant for SFDR are the ESG sustainability-related claims per products.”

And a spokesperson for ESMA, the European market watchdog, said SFDR is not ignoring short selling because the regulation “remains neutral in terms of design”. It is up to the hedge fund that discloses its ESG activity to “determine where, for example, its shorting activity is relevant to the disclosures.”

That said, hedge funds currently face limitations around sustainability calculations when it comes to using derivatives on which to base short positions. The European authorities developing the regulation’s reporting standards, known as RTS, say this is due to “an abundance of caution”.

Adam Jacobs-Dean, Global Head of Markets, Governance and Innovation at the Alternative Investment Management Association in London, says there has been “definitely not enough attention” in SFDR in the role it plays “in terms of how companies invest responsibly.” .

In the UK, where hedge funds play a more prominent role than in the EU, the Financial Conduct Authority is currently sorting out feedback on how its rulebook should address short selling, where an investor profits if an asset loses value.

“We recognize that a wide variety of ESG strategies are currently being observed in the market,” the FCA told Bloomberg. “These include a variety of alternative investment strategies, which may involve the use of traditional or custom derivatives to manage sustainability-related risks.”

Critics argue that there is an inherent conflict between short selling and sustainable investing. And even within the hedge fund industry there is a debate about the extent to which shorting, say, a company that uses fossil fuels actually reduces CO2 emissions.

The question is “whether you think you have more impact,” My-Linh Ngo, BlueBay Asset Management’s head of ESG investments, said in an interview. “If you say to a company: I’m not going to invest in you because I think you’re really bad, you don’t have a seat at the table. While if you go short, you sit at the table.”

Ultimately, regulations seem poised to dictate how much ESG money flows into hedge funds.

“If there’s one big lesson from SFDR, it’s that legislation and disclosure have the side effect of directing capital toward those products that are classified,” Man Group’s Mitchell said.

This post Hedge Funds encounter ‘really problematic’ rules driving ESG

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