The ‘dual outcomes of saving the world and generating excess returns’ has been made harder to deliver because of ESG scoring in emerging markets, a senior Aegon portfolio manager has said.
Aegon’s Phil Torres said emerging economies are put at an automatic disadvantage because emerging market debt is less attractive to investors.
According to Torres: “As stewards of capital, asset managers should find ways to partner with the poorer and most rapidly developing economies to help them grow, consistent with a sustainable world, and achieve deserved levels of welfare.”
“Nearly all responsible investors deploying capital in responsibly focused strategies, expect their investment will make a positive difference,” he said.
“This is especially true when investing in emerging markets debt.”
In his view a conventional approach to ESG investing in emerging market debt poses challenges.
In particular he feels there are four key structural features “keeping investors from realising their targeted outcomes” when investing responsible in emerging market debt.
Torres believes that if investment managers change the way they frame their approach to ESG, investors will have a greater chance of using their emerging market debt allocations to help improve societal outcomes.
Challenge 1: Data providers rank issuers on how the world affects issuers instead of how issuers affect the world
“Like traditional credit risk evaluation, most popular ESG scoring metrics are designed to reward an issuer by the degree to which it is immunised from the risks of operating and engaging with the world around it,” Torres said.
“Unfortunately, little emphasis is placed on evaluating how an issuer degrades the world, much less how to use this knowledge to create products and strategies designed to oppose these dominant trends.”
Challenge 2: ESG scoring methodologies are highly correlated with per capita wealth
According to Torres this penalises the poor and rewards the wealthy.
“Research indicates nearly 90 per cent of a country’s ESG evaluation is tied to the country’s wealth,” Torres said.
He highlighted that The World Bank goes further and has previously said, “A country’s national income permeates all sustainability-linked measures, used by the market.”
“Average ESG scores across providers are highly correlated with gross national income per capita, and by eliminating the income bias, results differ significantly,” Torres said.
Torres agreed with the World Bank’s statement that current ESG approaches are likely to divert necessary development dollars from poorer countries to the wealthier and “ultimately fail the overall responsible investing movement”.
“A country’s wealth and governance are also considered as a part of traditional rating agencies’ evaluation of an issuer. It compounds the weighting of this factor and explains the high degree of correlation between ESG scores and traditional credit ratings,” he said.
Challenge 3: There’s no such thing as a free lunch
Torres believes investors are reducing the likelihood of favourable financial outcomes.
“Generally speaking, the dominant academic conclusion is that expected excess returns typically fall when using any investment strategy that restricts,” Torres said.