In the pursuit of virtue premium: ESG investing in Asia
This article was written in November 2017
- In Asia ex Japan, ESG stocks recorded higher returns and lower volatility in the past 10 years
- 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
Global interest in ethical investments is growing as investors are increasingly recognising 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 lacklustre 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.
As time goes on, however, 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 annualised 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).
Fig. 1: Risk and return statistics (10-year) annualised
Taking volatility into consideration, Asian ESG leaders also outperformed their counterparts in the developed world — registering a much higher Sharpe ratio (Figure 2).
Fig. 2: Virtue Premium in terms of risk-adjusted returns
The favourable 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).
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 fuelled-power vehicles. This is a positive for BYD, driving its shares up 67% in the first 10 months of 2017. As a result 4 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 reputation risks in a globalised 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
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 process . 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’.
Source:
- International Monetary Fund (IMF): Asia Pacific Regional Economic Outlook Update, October 2017
- MSCI ESG Research, the MSCI AC Asia ex Japan ESG Leaders Index is a capitalisation 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.
- Berkshire Hathaway’s letter to shareholders, February 2010.
- 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.
- Bloomberg, total returns in Korean won with dividend re-invested, as of October 31, 2017.
- United Nations Principles for Responsible Investment (UNPRI), data as of April 30, 2017. Latest data available.
- CFA Institute, as of November 7, 2016. The results are from the survey of CFA Institute members on ESG issues on May 26, 2015.
