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.
When applied to ESG investing, ESG restrictions have the potential to reduce downside risk through credit enhancement, but they will also likely lower upside potential in Torres’s view.
“Further, issuers with better ESG scores typically are higher-rated credits, have lower cost of capital, and commensurate lower ex-ante asset returns. However, skilful forecasting of ESG can improve excess returns, particularly within the poorer, weaker countries.”
Torres believes that until asset managers adjust ESG scoring methodologies or portfolio weightings to neutralise the wealth and credit effects of conventional ESG approaches for emerging market debt issuers and portfolios, they must prepare to structurally underperform traditional benchmarks as a consequence of this ESG approach.
Challenge 4: Divestment rather than engagement often results in worse societal outcomes
In Torres’s view, investors should choose engagement rather than divestment when it comes to companies that are engaged in unethical or climate damaging practices.
“There are times when an issuer is simply so abhorrent or reckless that you cannot face the mirror knowing you are doing business with them. However, we believe speaking with and encouraging issuers to do better, by the world, can often be a successful strategy,” Torres said.
Overall, Torres believes emerging markets provide “intriguing opportunities” to accelerate the shift to a sustainable and inclusive global economy.
“Relative to developed markets that seemingly have abundant resources to meet a sustainable trajectory, emerging market companies and countries are often early in their journey. This offers opportunities to utilise capital to accelerate positive change,” he said.
Torres believes investing in emerging market issuers, that are interested in contributing to a more sustainable world, can create value over time, by aligning investments with issuers committed to improving their stakeholders' welfare and credit profile.
Examples include:
- Investing in sovereigns, quasi-sovereigns and corporates that are underpinned by strong governance with clear objectives in improving human welfare standards in a sustainable manner.
- Pursuing long-term value creation by combining traditional credit-based investing with long-term improvements in human capital.
- Measuring a commitment to sustainable change with a focus on governance, health, wealth, climate change, resource efficiency and economic/social rights.
- Relying on a research-intensive process and proprietary, country wealth-agnostic assessment framework to help understand how issuers might affect the world.
- Advancing positive outcomes by proactively engaging with issuers when possible.
jane.matthews@ft.com
