From investment approaches to regulatory change, environmental, social and governance (ESG) issues are at the forefront of any discussion relating to investing. The investment industry has to answer to increased demand from investors and greater scrutiny from regulators on ESG matters. In this roundtable interview, we hear from Vontobel ESG experts on their views on ESG as it relates to emerging markets. Sudhir Roc-Sennett, Head of Thought Leadership & ESG at the New York-based Quality Growth boutique, Lara Kesterton, Vontobel’s Head of mtx ESG Research, and emerging market local-currency bond Portfolio Manager Carl Vermassen offer their insights on the challenges and benefits of ESG in emerging markets investing.
Sudhir Roc-Sennet: For us, ESG is a long-term part of the investment undertaking that, if ignored, can lead to increased risks or underperformance in the future. We see ESG adding value the same way as getting health check-ups and taking care of health issues for people: it discovers and cleans up potential problems that you might face down the line, you know, in order to continue a healthy progression to your full potential and avoid issues turning into chronic problems.
In practice, for us as active managers, with concentrated portfolios and a long-term investment horizon, we are looking for sustainable earnings growth to drive the long-term performance of our investments. This means, on our part, having a deep understanding of the fundamentals of the business we invest in. Also, our views and the views of the management of the companies we invest in should be aligned.
We see ESG converging in equities to include elements of the traditional European approach, which is perhaps more organized, metrics-driven, and environmentally focused, with the more Anglo-sided engagement and bottom-up approach. I think these two are both coming together in a more uniform way with both sides benefiting from each other. It’s creating a more consistent set of understandings of how ESG can be effective. I wouldn't call it a 'standard', but I'd call it a more holistic appreciation and approach.
Diversity of the skill set and background is key. I think you need a team that is capable of looking at various aspects of a company. If all the analysts have a similar background, then you're more likely to miss something important. Also, it helps to have a strong team relative to the number of stocks being covered. We tend to have less than ten stocks per analyst, and for us, that has worked well to date, as it allows us to spend more time on each name and dig deep.
So, we have quantitative background people, we have fundamental background people, and we have ex-investigative journalists. We also have a broad range of geographic backgrounds with ten languages spoken across the team. This gives us the ability to see the same issue from a number of angles, and see risks or opportunities that might get brushed over by a narrower group.
Sure, for example, three of our team members are experienced ex-investigative journalists. Their skills are very complementary to fundamental research. They tend to have strong people skills rather than number skills. They do a lot of digging around issues on the ground. Maybe there are regulatory concerns, maybe there are issues on the way suppliers are treated, or maybe issues regarding background checks on a potential new CEO hire.
Yes. Governance challenges include regulatory ones, as regulators in emerging markets are not necessarily so aggressive in protecting minority shareholders, particularly foreign ones. A second is the issue of control. In emerging markets, you often have companies with controlling shareholders such as state-owned companies or family businesses. For minority investors, this means not just analyzing the company, but getting to grips with the goals of the controlling shareholders. Obviously, you do the corporate analysis but you also need to understand the goals of the controlling shareholder and not just the company as they report it.
Sudhir joined Vontobel in 2010 and has over 30 years of investment experience. He is Head of Thought Leadership & ESG for the Quality Growth Boutique based in New York and the author of the Turning Stones Blog, in which he discusses ESG issues related to investing.
Lara Kesterton: ESG for us is not about headline scores or binary tick boxes: ESG complements our fundamental company analysis by a thorough investigation of real-world issues that can have a significant impact on company performance. The greatest value-add is the ability to go in-depth and investigate critical issues – from allegations of forced labor in the supply chain, accounting irregularities, SOE interventions to compliance breakdowns. All recent examples of issues our ESG and sector-specialist financial analysts have dealt with. This often involves speaking with the company directly as well as canvassing outside opinions from accounting specialists or brokers who know the company well.
Our approach is not a best-in-class approach – therefore ESG does not pre-define our investment universe. Rather (and on the back of much academic and quantitative research), our approach is to avoid companies with significant and unmanaged ESG risks. As such, ESG is one of the main pillars in our investment approach – from a narrow field of financially attractive companies (in particular high return on invested capital, ROIC), our detailed ESG investigations seek to root out companies most exposed to the traps and shocks that could harm performance. Our quantitative research shows that, for our ROIC-focused investment strategy, avoiding the worst ESG performers is a particularly appropriate ESG strategy in emerging markets.
Be systematic, focused, dig deep when you find issues, and build your own picture of company performance from many sources. We would caution against various pitfalls of blindly adopting headline ESG ratings. Keep your clients informed – ESG is a hot area of interest so report regularly on what you’re doing on that front.
While we have a systematic approach to objectively assess companies on their ESG risk management, we need to remain aware that ESG is still a young field and is evolving fast. Therefore, it is important to read a lot and widely, participate in industry conferences, be open-minded to learn from others, and adapt your approach. There are many different ways to approach ESG, and certainly no one “right” way. Building deep sectoral and topic knowledge can help to navigate the various real-world conundrums that come up that do not fit neatly into pre-set frameworks.
Another tip is to speak with your investee companies when possible and bring ESG matters to the table. We find this to be a useful source of strategic insight on how they assess and manage top ESG risks and the level of commitment to deal with problem areas. Something that can be harder to decipher from public reports. Engagement is particularly valuable in emerging markets and when you don’t have a best-in-class approach.
There are two sides to this: First, ESG data difficulties mean one has to work harder to get to a robust risk management analysis – but the results of such investigations can give competitive insights. Second, emerging-market companies can be more exposed to both systematic and stock-specific risks from ESG factors. EM companies are at the sharp edge of ESG risks due to weaker regulations, less enforcement, less scrutiny by the civil sector, and a weaker reporting culture than in DM, for example.
This means that an active ESG manager needs to do more homework themselves to form an accurate picture of risk management. Our quantitative analysis also showed that while in developed markets, one might take a best-in-class or top-50% approach to ESG selection, in emerging markets this could hurt performance. We found that for our investment approach in EM, excluding the worst ESG performers delivers outperformance over the long term.
Governance is a particularly important pillar in emerging markets and is commonly raised as the major differentiator between EM and DM companies.
In emerging markets, board independence tends to be lower than in developed ones, so special attention is needed on the quality and skill set of the board – will they be “yes men” (and they are still predominantly men) to the executives or rather provide good checks on management in the interests of minority shareholders and other stakeholders?
In emerging economies, state-owned enterprises and family-controlled firms are more prevalent, these ownership structures are often associated with market underperformance as there is a greater risk of prioritizing political, social, or private ends over shareholder value.
A key area of concern is the rights and protections for minority shareholders, in particular, where governance structures further minimizes their voice. A deeper analysis of the board’s track record vis-à-vis the long-term interests of minority shareholders is therefore needed. To overcome the information gaps, it is important to undertake more proprietary research and engage directly with companies.
Lara joined Vontobel in 2017 as an ESG consultant and now leads ESG research for the mtx boutique. She is a lawyer, with five years’ practice in a leading London law firm, specializing in banking and international finance. She holds a Master of Science degree in Environmental Change & Management from Oxford University and has worked with a number of private equity groups on renewable energy investments.
Carl Vermassen: We believe strongly in ESG at the normative level and the risk-return level. If you do away totally with the normative aspect, – by normative I mean being a force for good – then I don't know exactly what the difference there is between ESG and just ordinary good asset management.
So, we want to be a force for good. We want to be engaging, but for us who deal with sovereign bonds, it's a lot more difficult to have an impact on a country’s governance than say an equity manager can have on a single company’s governance.
It feels as if everyone has a view on emerging-market countries – how they should do policy, how they should run their economies, and how they should run their societies, and it's not because an investor that says it that, all of a sudden, a country will change tack. However, we do engage on the governance level in meetings with officials, for example. For this to have a meaningful impact, though, does require more than just one investment manager.
We believe that doing good improves your long-term risk-return in emerging economies. For us who specialize in local-currency sovereign bonds from an ESG angle, the stability of the countries whose bonds we invest in is a key factor. The general belief is that stable societies generate stable growth, and for stable growth, you need a confident middle class. Most autocracies are not really interested in the middle class. They are interested in making things better for themselves. They create a sort of self-serving elite, and they have a big lower class, which they hope will stay lower class – for the simple reason that an emerging middle class tends to start demanding rights. A growing middle class has buying power, which invigorates economies. Therefore, for us, countries that may be poor in ESG from a developed-market perspective, but which are on a trajectory where there is a growing middle class, are of interest. In our view, there's more difference to be made in emerging-market assets compared to developed-market assets. Most developed markets are pretty much “ESG” if you compare them to most emerging economies, so there's more to be done at the level of ESG in emerging markets than in developed ones.
There are two ways that ESG plays into our approach. One is exclusions – we do not invest in a country that is deemed authoritarian by Freedom House, full stop. That does make quite a difference. If you look for example at the JP Morgan ESG indices, they exclude something like 6% including countries like Russia, Turkey, and China, while we exclude the totality, so it does make quite a difference. It's also the reason why we say we don't manage against the benchmark. We consider the benchmark to be an average peer, but we are not continuously managing against it. This is the exclusion part.
The other part where ESG plays into our approach is what we call a modified best-in-class. It's our ranking model. Why do I call it “modified”? Best-in-class typically is going to look at indicators and ranking of countries, and it's going to cut off, for example, the 10%, the 25% or even the 50% of lower-risk countries on a certain ranking. That is not what we do. Non-authoritarian countries remain investable, but the average sustainability score, the weighted sustainability score, of our portfolio has to be above a sustainability threshold. So, basically, yes, we can invest in a non-authoritarian, little frontier country that is somewhat behind on general ESG, if we compensate it by investments into more sustainable countries to get our average back above this sustainability threshold. This keeps our overall portfolio on a sustainable level, while allowing us to invest in countries where we see ongoing improvements in ESG:
Investors will become more demanding for sure. By demanding, I mean more knowledgeable. They will look out for things like greenwashing – many of them already do. They will also demand more reporting, which is inevitable and also a good thing. Increased regulation will also require more reporting. This will put pressure and require more resources from asset managers. All in all, if you claim to be ESG, you will have to prove it through reliable and thorough reporting.
Carl joined Vontobel in January 2019 and has nearly 30 years of investment experience. He holds a degree in Applied Economic Sciences from the University of Antwerp and he is a senior portfolio manager specializing in sustainable emerging market local-currency bonds.
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