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Summary

§ 
In Asia ex Japan, ESG
stocks recorded higher returns and lower volatility in the past 10 years

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§ 
A growing number
of PRI signatories is an indicator of increasing awareness of ESG investments

§ 
Asian corporations
are striving to incorporate ESG factors in their operations

§ 
Active investment
managers can add value by identifying future Asian ESG leaders

 

The market for “Virtue
Premium”: ESG investments in Asia  

Global interest in ethical investments is growing as
investors are increasingly recognizing that environmental, social and
governance (ESG) factors play a material role in determining risk and return, in
the belief that ethically conscious businesses are more sustainable. However, skeptics
argue that focusing on anything beyond traditional financial metrics can only lead
to lackluster investment performance. In this article, we would like to illustrate
that Asian equities can, in fact, offer investors a good opportunity to add
value to their investments by encompassing ESG factors.

Higher returns from
Asian ESG leaders

The robust growth of Asian economies, led by China and
India, is beyond doubt. Indeed, Asia is expected to remain the key driver of
the world economy, with an expected gross domestic product (GDP) growth of 5.5%
for 20181.  Yet, whilst seeking economic growth, many Asian
companies are more known for making money at the expense of ignoring climate
and social issues such as carbon emission and water pollution – let alone the
poor work conditions and weak corporate governance.

However, as time goes on, and with Asian companies facing
increasing regulations and a growing number of institutional investors as signatories to the UN Principles for
Responsible Investments (PRI), more companies appear to be considering ESG issues
in their operations.

In
the past 10 years, the MSCI AC Asia ex Japan ESG Leaders index2
generated an annualized return of 5.55%, outperforming its broader market by
2.75% points, whilst the ESG leaders in developed markets paled in comparison
(Figure 1). Taking volatility into consideration, Asian ESG leaders also outperformed
their counterparts in the developed world – registering a much higher Sharpe
ratio (Figure 2).

The favorable discrepancy of Asian ESG leaders over the
broader market – sometimes known as “Virtue Premiums” – can be attributed to the
fact 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 such
as Warren Buffett, who tend to stay with these virtuous companies rather than
flipping shares for short-term gains. This can also help lower the turnover
rate, helping institutional investors to improve their long-term Alpha (excess
return).

Figure 1: Risk and
return statistics (10-year) annualized

Source:
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 Japan
Leaders index was launched in March 2017. Data prior to the launch date is
back-tested.

 

Figure
2: “Virtue Premium” in terms of risk-adjusted returns

Source:
MSCI ESG Research, gross returns in US dollars, as of October 31, 2017.

High-performing ESG investments

ESG investors do not simply avoid companies or industries
considered unethical. Instead, they seek out companies that act on ESG
principles. BYD, a Mainland Chinese battery and electric car maker, is a very
good example of a high-performing environmentally responsible investment.

Since
Warren Buffett’s Berkshire Hathaway bought a 9.9% stake for US$232 million in
September 20083,
it has stayed with BYD through its ups and downs. The share prices of BYD increased
rapidly in 2009 but then tumbled in 2010 and 2011 before picking up again in
2012. In recent years, the stock regained momentum as China began pushing to
replace fuel-consuming vehicles on its roads and recently announced plans to
ban the production and sales of fossil fueled-power vehicles. This is a
positive for BYD, driving its shares up 67% in the first 10 months of 2017. As
a result of this recent run, Berkshire Hathaway’s stake is now worth about US$1.97
billion4.  

A high degree of state ownership and complex ownership structures
is another issue that usually undermine a company’s ESG ratings. For example,
state-owned-enterprises (SOEs) in China are more prone to political meddling as
they are accountable only to the central or provincial governments, rather than
minority shareholders and/or its employees. Similarly in South Korea,
complicated ownership structures in the Chaebol business groups are in place to
protect the family control – one of the last things that ESG investors want to
see.

The “Vice Premium” of
sin stocks

Samsung Electronics, however, has been a high-performing
stock. The South Korean technology giant is infamous for its complex ownership structure
that keeps its family control unchallenged. In August 2017, Lee Jae-yong, the
vice chairman of Samsung and the de facto head of the country’s largest
company, was sentenced to five years in prison for corruption. The verdict is likely
the result of poor corporate governance, creating a major blow to the company’s
global reputation already affected by the embarrassing recall of its fire-prone
Note 7 smartphone in 2016.

In spite of this, shares of Samsung have been
outperforming the KOSPI index in the past 10 years5.
This impressive performance is a classic counter example to ESG investing. And
that’s one of the reasons why some investors remain fond of investing in the
so-called “sin stocks”, such as tobacco, alcohol and gambling companies, to
enjoy their “Vice Premiums”.

 

Growing appetite among
institutional investors

But ESG investing is not only about investment returns (Figure
3). 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 investment
managers’ fiduciary duty to lower value-destroying reputational risks in a
globalized world where social media is the new norm. It’s about social responsibility.

It is for this reason
that 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 their
selection process of fund managers investing in Asia. We can also see a growing
number of institutional investors that are signatories to the UN PRI. In 2006, there were only 63 PRI
signatories but this number increased to 1,714 in April 20176.
As signatories, institutional investors have a duty to act in the best
long-term interests of their beneficiaries.  

 

Figure 3:
Reasons to consider ESG in investment analysis/decision

Source:
CFA Institute, as of November 7, 2016. The results are from the survey of CFA
Institute members on ESG issues on May 26, 2015.

More Asian
corporations to raise ESG standards

In Asia, ESG investing presents a good opportunity for
investors to secure “Virtue Premiums” when compared with their counterparts in
the developed world. This, coupled with the
considerable appetite for ESG practices, creates both opportunities and
challenges for investment managers to integrate ESG in their investment process7.
These include building up knowledge of ESG assessments, and deciding how to
incorporate ESG metrics from third-party research providers. Active managers
who are in pursuit of excess returns will also conduct their own research to
examine a company’s ESG performance, rather than just outsourcing analysis to a
third party. This can assist in identifying candidates as future Asian ESG
leaders, helping investors add value in an ethical way.

 

Nowadays, Asian countries such as China, India,
Malaysia, Indonesia, Taiwan and Singapore are adapting public policies and
regulatory frameworks to encourage companies to take ESG factors into account
when doing business. In the long run, we expect that there will be more Asian
corporations matching their ESG standards with the developed world – creating
more ethical investments for investment managers to choose from, and thereby,
closing the “Virtue Premiums”.

 

1 Source: International
Monetary Fund (IMF) Asia Pacific Regional Economic Outlook Update, October 2017

2 Source: MSCI ESG
Research, the MSCI AC Asia ex Japan ESG Leaders Index is a capitalization
weighted index that provides exposure to companies with high Environmental,
Social and Governance (ESG) performance relative to their sector peers. MSCI AC
Asia ex Japan ESG Leaders Index consists of large and mid-cap companies across
2 of 3 Developed Markets (DM) countries (excluding Japan) and 9 Emerging
Markets (EM) countries in Asia.

3 Source: Berkshire
Hathaway’s letter to shareholders, February 2010.

4 Source: Bloomberg, share
price as of October 31, 2017. Berkshire Hathaway bought 225,000,000 shares of
BYD, representing 9.9% of BYD’s share capital at that time. Now the holdings
represent 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 for
Responsible Investment (UNPRI), data as of April 30, 2017. Latest data available.

7 Source: CFA
Institute, as of November 7, 2016. The results are from the survey of CFA
Institute members on ESG issues on May 26, 2015.

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