Summary§ In Asia ex Japan, ESGstocks recorded higher returns and lower volatility in the past 10 years § A growing numberof PRI signatories is an indicator of increasing awareness of ESG investments§ Asian corporationsare striving to incorporate ESG factors in their operations§ Active investmentmanagers can add value by identifying future Asian ESG leaders The market for “VirtuePremium”: ESG investments in Asia Global interest in ethical investments is growing asinvestors are increasingly recognizing that environmental, social andgovernance (ESG) factors play a material role in determining risk and return, inthe belief that ethically conscious businesses are more sustainable. However, skepticsargue that focusing on anything beyond traditional financial metrics can only leadto lackluster investment performance. In this article, we would like to illustratethat Asian equities can, in fact, offer investors a good opportunity to addvalue to their investments by encompassing ESG factors. Higher returns fromAsian ESG leadersThe robust growth of Asian economies, led by China andIndia, is beyond doubt. Indeed, Asia is expected to remain the key driver ofthe world economy, with an expected gross domestic product (GDP) growth of 5.
5%for 20181. Yet, whilst seeking economic growth, many Asiancompanies are more known for making money at the expense of ignoring climateand social issues such as carbon emission and water pollution – let alone thepoor work conditions and weak corporate governance. However, as time goes on, and with Asian companies facingincreasing regulations and a growing number of institutional investors as signatories to the UN Principles forResponsible Investments (PRI), more companies appear to be considering ESG issuesin their operations. Inthe past 10 years, the MSCI AC Asia ex Japan ESG Leaders index2generated an annualized return of 5.
55%, outperforming its broader market by2.75% points, whilst the ESG leaders in developed markets paled in comparison(Figure 1). Taking volatility into consideration, Asian ESG leaders also outperformedtheir counterparts in the developed world – registering a much higher Sharperatio (Figure 2). The favorable discrepancy of Asian ESG leaders over thebroader market – sometimes known as “Virtue Premiums” – can be attributed to thefact that the development of ESG practices in Asia is still at a nascent stage.This has indeed made ESG stocks more appealing in Asia to discerning investors suchas Warren Buffett, who tend to stay with these virtuous companies rather thanflipping shares for short-term gains. This can also help lower the turnoverrate, helping institutional investors to improve their long-term Alpha (excessreturn).
Figure 1: Risk andreturn statistics (10-year) annualizedSource:MSCI ESG Research, gross returns in US dollars, data as of October 31, 2017.Sharpe ratios are calculated based in ICB LIBOR 1M. The MSCI AC Asia ex JapanLeaders index was launched in March 2017.
Data prior to the launch date isback-tested. Figure2: “Virtue Premium” in terms of risk-adjusted returnsSource:MSCI ESG Research, gross returns in US dollars, as of October 31, 2017.High-performing ESG investmentsESG investors do not simply avoid companies or industriesconsidered unethical. Instead, they seek out companies that act on ESGprinciples. BYD, a Mainland Chinese battery and electric car maker, is a verygood example of a high-performing environmentally responsible investment. SinceWarren Buffett’s Berkshire Hathaway bought a 9.9% stake for US$232 million inSeptember 20083,it has stayed with BYD through its ups and downs. The share prices of BYD increasedrapidly in 2009 but then tumbled in 2010 and 2011 before picking up again in2012.
In recent years, the stock regained momentum as China began pushing toreplace fuel-consuming vehicles on its roads and recently announced plans toban the production and sales of fossil fueled-power vehicles. This is apositive for BYD, driving its shares up 67% in the first 10 months of 2017. Asa result of this recent run, Berkshire Hathaway’s stake is now worth about US$1.97billion4. A high degree of state ownership and complex ownership structuresis another issue that usually undermine a company’s ESG ratings.
For example,state-owned-enterprises (SOEs) in China are more prone to political meddling asthey are accountable only to the central or provincial governments, rather thanminority shareholders and/or its employees. Similarly in South Korea,complicated ownership structures in the Chaebol business groups are in place toprotect the family control – one of the last things that ESG investors want tosee. The “Vice Premium” ofsin stocksSamsung Electronics, however, has been a high-performingstock. The South Korean technology giant is infamous for its complex ownership structurethat keeps its family control unchallenged. In August 2017, Lee Jae-yong, thevice chairman of Samsung and the de facto head of the country’s largestcompany, was sentenced to five years in prison for corruption. The verdict is likelythe result of poor corporate governance, creating a major blow to the company’sglobal reputation already affected by the embarrassing recall of its fire-proneNote 7 smartphone in 2016. In spite of this, shares of Samsung have beenoutperforming the KOSPI index in the past 10 years5.
This impressive performance is a classic counter example to ESG investing. Andthat’s one of the reasons why some investors remain fond of investing in theso-called “sin stocks”, such as tobacco, alcohol and gambling companies, toenjoy their “Vice Premiums”. Growing appetite amonginstitutional investorsBut ESG investing is not only about investment returns (Figure3). Look at Union Carbide’s gas leak at its pesticide plant in India (1984),the appalling conditions of workers at McLeod Russel’s tea gardens in India(2016) and Kobe Steel’s fake data scandal (2017) as examples. It is also about investmentmanagers’ fiduciary duty to lower value-destroying reputational risks in aglobalized world where social media is the new norm.
It’s about social responsibility. It is for this reasonthat an increasing number of institutional investors (such as sovereign wealth funds,insurance companies and pension funds), who want to safeguard their reputation,are embedding ESG questionnaires in theirselection process of fund managers investing in Asia. We can also see a growingnumber of institutional investors that are signatories to the UN PRI.
In 2006, there were only 63 PRIsignatories but this number increased to 1,714 in April 20176.As signatories, institutional investors have a duty to act in the bestlong-term interests of their beneficiaries. Figure 3:Reasons to consider ESG in investment analysis/decisionSource:CFA Institute, as of November 7, 2016.
The results are from the survey of CFAInstitute members on ESG issues on May 26, 2015.More Asiancorporations to raise ESG standardsIn Asia, ESG investing presents a good opportunity forinvestors to secure “Virtue Premiums” when compared with their counterparts inthe developed world. This, coupled with theconsiderable appetite for ESG practices, creates both opportunities andchallenges for investment managers to integrate ESG in their investment process7.These include building up knowledge of ESG assessments, and deciding how toincorporate ESG metrics from third-party research providers. Active managerswho are in pursuit of excess returns will also conduct their own research toexamine a company’s ESG performance, rather than just outsourcing analysis to athird party. This can assist in identifying candidates as future Asian ESGleaders, helping investors add value in an ethical way. Nowadays, Asian countries such as China, India,Malaysia, Indonesia, Taiwan and Singapore are adapting public policies andregulatory frameworks to encourage companies to take ESG factors into accountwhen doing business. In the long run, we expect that there will be more Asiancorporations matching their ESG standards with the developed world – creatingmore ethical investments for investment managers to choose from, and thereby,closing the “Virtue Premiums”.
1 Source: InternationalMonetary Fund (IMF) Asia Pacific Regional Economic Outlook Update, October 20172 Source: MSCI ESGResearch, the MSCI AC Asia ex Japan ESG Leaders Index is a capitalizationweighted index that provides exposure to companies with high Environmental,Social and Governance (ESG) performance relative to their sector peers. MSCI ACAsia ex Japan ESG Leaders Index consists of large and mid-cap companies across2 of 3 Developed Markets (DM) countries (excluding Japan) and 9 EmergingMarkets (EM) countries in Asia.3 Source: BerkshireHathaway’s letter to shareholders, February 2010.
4 Source: Bloomberg, shareprice as of October 31, 2017. Berkshire Hathaway bought 225,000,000 shares ofBYD, representing 9.9% of BYD’s share capital at that time.
Now the holdingsrepresent 24.59% of BYD.5 Source: Bloomberg,total returns in Korean won with dividend re-invested, as of October 31, 2017.6 Source: United Nations Principles forResponsible Investment (UNPRI), data as of April 30, 2017. Latest data available.7 Source: CFAInstitute, as of November 7, 2016.
The results are from the survey of CFAInstitute members on ESG issues on May 26, 2015.