Questions surfaced whether environment, social, and governance (ESG) investing would become an afterthought as businesses grappled with the novel coronavirus. Interest rates were cut, public deficits rose, and regulations were relaxed in order to prevent an economic collapse.
Even as markets recovered and economies selectively reopened, months of home working and social distancing have amplified calls to promote sustainability. Speaking virtually at Principal’s 2020 Global Summit, Jean Claude Juncker, Former President of the European Commission, suggested that all nations need to incorporate new modernisation policies and incomes sources to cement a structured recovery from the current health crisis.
With central banks cutting interest rates and governments running fiscal deficits, very few good options are available to restore financial prudence, explained Junker. “Outstanding government debt means higher interest rates would be a disaster. The adjustments need to be achieved on the fiscal side by expanding the tax base, including a plastic tax.”
Helping its cause, ESG-related funds have outperformed. The MSCI World ESG Leaders Index has returned 5% year to date, about a hundred basis points better than the MSCI World Index. At the end of the second quarter, ESG assets under management (AUM) sat at over $1 trillion by mid-year.
The obvious first layer, but less obvious preceding layers
Limited exposure to energy stocks partially explains the outperformance.
With trade and people movement at a standstill, Brent crude has fallen 40% this year, approximately the same losses registered on the MSCI Energy Index. Meanwhile, the MSCI Global Alternative Energy Index has returned that amount.
Most agree that traditional energy, particularly oil and coal, should score lower than renewable energy on any ESG rating. But selecting a universally accepted ESG benchmark compounds the challenge for responsible investing.
“Ultimately the fund manager makes this call,” says Raymond Chan, Chief Investment Officer at Hamon Investment Group, speaking to FinanceAsia. “There needs to be an angle in the selection criteria [to meet] either a global perspective or components of ESG."
But alongside ESG’s popularity is growing criticism that responsible investment mandates fail to meet their goals. Among the top ten performing large cap funds that incorporate ESG practices, eight are heavily concentrated in US technology names, the driver for the recent equity rally. Information technology accounts for more than a fifth of the MSCI World ESG Leaders index.
And here lies the gap between the perception and reality to what responsible investing entails and should do. ESG awareness is occurring at different investment cycles across markets. While European institutional managers are pushing a responsible agenda and American retailers are building public awareness, emerging countries still rely on traditional, less ESG friendly sectors to drive growth.
“When you say that Asian companies are meeting ESG criteria, some Europeans will laugh at you, since they might have a very different selection perspectives from what Asian based fund managers imagine” explains Chan.
“High scoring Asian ESG companies could simply be the local bourses enforcing disclosures earlier than other exchanges, reflecting the nature of the [asset classes] development,” which on the surface does not profess any responsible or implementation actions taking place.
An Impossible Trinity
“Criticising the investment process is not damaging, as this improves the underline cause over the long run,” says Neil Mascarenhas, lead Fund Manager for the Hamon ESG Strategy which will be launched later this year.
“Understanding the business risks and operations matter more than selecting stocks off a scorecard, which often miss visible changes that encapsulate the spirt of ESG.”
Because starting points are different, ESG investing faces an impossible trinity. Growth of lower costs, minimum risk, passive funds may not be able to meet these responsible objectives that shareholders hope.
Indirectly, this suggests that true ESG funds will become strong conviction portfolios, entailing higher tracking errors (relative to the benchmark), where “ESG lies in the integration of those principals and mindset in the investment process, not the end product,” says Mascarenhas.
With inconsistent ESG reporting by some listed companies, asset managers turn to third party data providers. However, because specific methodologies may not include the entire eligible investment universe, the process displays inherited limitations.
For example, smaller cap stocks would be at a disadvantage. MSCI ESG ratings cover more than 95% of China’s CSI constituents, but only a third of MSCI China A Onshore Mid-Small Cap Index, according to a note by Manulife Investment Management.
Work is being done to harmonise this information. Earlier this month, the International Organisation of Securities Commission announced plans to uniform rules for disclosing responsible investing.
Inevitably, all will adapt in order to raise their responsibility score. Traditional oil companies have begun writing down their exploration businesses, which scores lower on most ESG metrics. European automakers are doing the same with their legacy businesses and investing more towards electronic vehicles, raising their green profile to attract thematic capital.
But ESG investing needs to separate itself from marketing, as currently the “ESG movement is more about being seen to be doing something rather than actually doing it,” writes Christopher Wood, equity strategist at Jefferies in a note earlier this year.
Citing why gold royalty companies have outperformed gold mining stocks this year, Wood explains that “because most mining companies are not investable from an ESG standpoint. Whereas gold royalty companies are not involved in the actual ‘dirty’ practice of mining.”
Better ESG investing which meets responsible objectives will likely remain a key critical component for active fund management, given that human interpretations are still needed where the data falls short. This is particularly true in Asia, given cultural differences across countries.
But this also entails more convincing reforms to improve the process. For Asian ESG investments, to be taken seriously, more criticism is expected, possibly in the form of laughter.
