Gonzalo Pángaro, portfolio manager, emerging markets equity strategy, at T. Rowe Price, believes that ESG is a key component of the investment process. ‘It informs investors about the quality of a company and identifies material risks to the sustainability of its long-term growth,’ he states.
Beware of the index
Passive managers, however, often struggle with ESG investing as they have to own the index, making no allowance for a company’s ESG behaviour and risks. There is a wide variance between different companies on their approach and consideration of ESG criteria.
Incorporating ESG principles into an active investment approach meets these challenges head on. According to Ernest Yeung, portfolio manager at T. Rowe Price, this is particularly the case in emerging economies where the value potential of so-called forgotten companies is either unrecognised or not fully understood. ‘There remains a general perception among investors of an “ESG shortfall” when it comes to emerging markets. This broad‑brush view, however, presents good opportunities for active investors. By identifying mispriced stocks, where strong or improving ESG standards are being underappreciated, they can benefit from long‑term price improvements.’
T. Rowe Price, for example, developed its own proprietary ESG analysis via a Responsible Investor Indicator Model (RIIM), which proactively and systematically analyses the profiles of more than 14,000 companies. For example, in the environmental section, the model identifies climate change considerations beyond greenhouse gas emissions. ‘While carbon is the focus of public debate and data is widely available, we believe limiting analysis to this factor is short-sighted,’ Yeung says. ‘Many other climate change factors – such as water availability, local pollution and waste management – are more likely to be catalysts for regulatory change.’
He adds that most companies will feel a pull and push effect from climate change factors through different aspects of their business model. Food companies, for instance, may benefit from consumer demand for organic products, but suffer when a drought affects its agricultural supply chain. Semiconductor manufacturers benefit from digitisation, a notable portion of which is driven by energy efficiency, but then face an operational risk based on power and water supplies. ‘In these cases, it is about understanding how a company is managing its climate change exposure and the adaptability of its business model to a lower carbon world,’ Yeung points out.
In contrast to passives, which have the propensity to disregard the level of ESG adherence as long as the company ticks the necessary boxes, active strategies are also able to take the degree to which ESG practices are followed into account.
Thus, active managers can make well-founded decisions in less obvious, grey-area ESG cases. For example, a company that has a thought-through ESG roadmap in place, but has only recently started its journey, may not be able to demonstrate stellar ESG credentials just yet. The potential, however, is there. While these opportunities often go unnoticed by passive investment strategies, active managers are able to capitalise on them.
Data and scoring remain biggest ESG hurdles
Active ESG investing in emerging markets does not come without its pitfalls though. The limited access to data, for example, can lead to mispricing. That is why ESG scores for the same company can differ significantly, depending on the datasets that have been used to determine them. It all comes down to the quality of data in the rating process.
‘Particularly within emerging markets, ESG research can be inconsistent, with much of the available third‑party data outdated or backward looking,’ Yeung says. ‘Being able to draw upon timely ESG analysis, where factor materiality is the primary focus, adds an important and differentiating component to investment decision making.’
Scoring ESG factors represents another issue. Simply put, the main imperative of ESG investors adds up to ‘do well and do good.’ But while portfolio managers usually have sets of criteria at their disposal to assess the ESG-friendliness of their investments, translating the ‘do well’ into numbers can be tricky.
There are ways to measure the relative value of ESG metrics, though. By comparing ESG scores to an index, benchmarking portfolios against peers or referring to personal performance levels in the past, active managers are able to quantify their ESG outcomes regardless.
ESG investing may have reached the mainstream, but it is still in its infancy in emerging markets. But investors say this is about to change. Yeung says: ‘Our experience is that there is an increasing appetite for engagement among emerging market companies – a keenness that is sometimes stronger than that exhibited by their developed market counterparts.’
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