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Investigating ESG For Alpha Generation

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  • Environmental, Social and Governance (ESG) policies are an important measure of risk mitigation and are an alternative signal for alpha
  • Emerging markets typically have less opportunity for ESG evaluation, but answers are available and incentive is high to uncover and evaluate

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As man-made risks that include climate change, data privacy and corruption continue to grow and evolve, a company’s values and policies to mitigate against them through a developed ESG framework must be fit for purpose to protect long term growth and ensure investor support.

As Mercer identified in 2015 -“Investment that considers sustainability isn’t about changing the world – it’s about understanding how the world is changing.”  

In recent years a growing number of climate and socially conscious investors have been demanding portfolios in line with their own values. There is now a growing body of knowledge, led by MSCI’s ESG research group, that points to the possibility for increased return when conscious of ESG policies during portfolio construction. Their paper released in 2015, a time when concerns of profit impact were still widespread, showed that overweighting companies with higher or improving ESG ratings led to increased performance over global benchmarks.

MSCI now has ESG ratings on over 6000 public companies on a AAA-CCC scale, and evaluates 5 factors: Values, Global Sanctions, Global Norms, Carbon & Clean Tech and Controversies. ESG evaluation has advanced significantly in recent years, much down to the evolution in data creation and storage that has been the catalyst behind the leap forward in non-traditional, non-financial investment research. But it is no surprise that without the opportunity to capture and analyse this data, assessing ESG in emerging markets is difficult and noisy. As Egon Vavrek, an EM equities portfolio manager at APG Asset management points out, “…data collection and monitoring of developed market companies have become significantly more prudent and accurate, while emerging market corporates have been left behind…”

As with all other forms of data generated insight or ‘Alt Data’, investing in solutions to uncover occurring or pending controversy is at its most valuable when in the hands of the few. Whilst it is more resource intensive, investigating ESG in emerging market companies through offline information acquisition provides hard to reach insight ahead of the market and delivers value across investment strategies.

Comparing ESG indexes against their benchmarks illustrates the alpha potential, and for emerging markets it is significant. The EM ESG leaders index, made up of 417 public companies that exclude any involvement in alcohol, gambling and arms trading and score highly on ESG rating, is currently outperforming MSCI EM by over 50 points. The benchmark typically does not include state owned enterprises due to low ratings over poor labor relations, polluting concerns and a lack of transparency and accountability, according to Alan Brett, a VP at MSCI.

Investigating ESGWith the EM ESG Leaders index YTD returns at double that of ACWI ESG Leaders, and forecasts increasing into 2018, identifying highly rated ESG companies in opaque markets could prove fruitful. But without the same data and transparency in developed markets, investigation into the broadening range of controversies that can hit an organisation is critical to understand, uncover and evaluate true risk. As emerging markets continue to fragment and ‘EM investing’ becomes more disjointed, the potential for controversy that will negatively impact management and investors is high and a proactive approach is optimal.

Investigating ESGThorough and pre-emptive examination of potential ESG, reputational and security concerns should apply across public and private markets and allows for insight regardless of investment strategy; knowledge of this nature can be exploited in a number of ways. The indicators identified by MSCI can be researched and investigated systematically at ground level through local sources and expertise, when the data in unavailable.

Just as MSCI identified Equifax’s insufficient cyber security protocols in August 2016, over 12 months before the announcement of the data breach, investigating ESG can provide similar early signals before the market and competitors. Cambridge Associates, in their 2016 research note on the Value of ESG Data in emerging markets, draw on the example of Petrobas. During a period of high oil prices and accelerated growth in the Brazilian economy, in 2008 Petrobas stock was trading at over $70 per share. However, significant governance issues were being overlooked by investors and the subsequent demise of the company has been well documented. By 2016, an estimated $3bn of bribes had been uncovered and the stock price had at one point dropped as low as $2.90 ps.

For EM investors, a great deal more resource is necessary to uncover concerning activities, but a comprehensive, multi-strategy and investigative approach will provide increased and safer returns from emerging market ESG investing.

Article by Thomas Tippetts Director of OMYTIS, a New York based Strategic Intelligence Advisory

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