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DWS & ESG: Separating the wheat from the chaff

Synopsis: The last week has been tumultuous for the DWS group. On Thursday, 26th of August, there were reports that one of the largest global asset management firms is being investigated by the U.S. and German authorities over the exaggerated claims it made about its sustainable investing practices. The stock price of DWS Group corrected 15% in two days (Thursday and Friday, 26th and 27th of August 2021) and it has not yet recovered. Does this mean that the investors have already assumed that the firm is guilty? Irrespective of what the market view is, it is clear that the market is ascribing a significant probability to a bad outcome from the regulator’s probe. It is a more balanced outcome for the ESG ecosystem and positive long-term development for the ESG movement. The asset managers were asserting themselves that the companies should reform and they need to do more to become proactive on their sustainability efforts. But the regulators have proven that the asset managers themselves will be held accountable and the onus will be on them to prove that what they are saying on the ESG strength of their portfolio is backed by solid evidence. There are other important messages in this DWS episode. The good news in our view is that the regulators are now not unsure about the relevance of ESG. They are not debating if sustainability filters are good or bad, are they useful or are they not, and if ESG is a fad that will subside with time. The regulators have perhaps realized that it will be futile to fight the global ‘ESG’ trend. This is a major positive development for ESG advocates as this development indicates that the ‘whether’ or ‘if’ part has been resolved. ESG is here to stay and the regulators have accepted it. The next task for the regulators is to figure out the ‘how’ of ESG investing and to ensure that there is a level playing field. So, in many ways, this is a big win for the global ‘sustainable finance’ industry and indeed, great news for the planet and humanity. It is a major progressive step from regulators and could prove to be the harbinger of a new era in ESG investing.

DWS Group: Alas, the double-edged sword which ESG is

The last week has been tumultuous for the DWS group. On Thursday, 26th of August, there was news that one of the largest global asset management firms and the now separate erstwhile Deutsche Bank’s asset-management firm, DWS Group, is being investigated by the U.S. and German authorities over the exaggerated claims it made about its sustainable investing practices. The authorities began investigating if the firm deliberately exaggerated the sustainability claims in some of its ESG-labeled investment products, to make them more attractive than they were, in reality.

According to the reports across several media channels, the federal prosecutors in the USA and the Securities and Exchange Commission (SEC) are probing DWS after the company’s former head of sustainability said the firm had exaggerated its use of sustainable investing criteria to manage assets. Just like the investigations in the US, the Financial Times reported that BaFin, the German regulator, has launched an investigation into DWS to find out if it was misrepresenting the usage of ESG metrics to analyze companies across its entire investment platform. DWS Group refuted the allegations, but the market was naturally worried. The stock price of DWS Group corrected 15% in two days (Thursday and Friday, 26th and 27th August 2021), with a major decline contributed by the big fall on Thursday, 26th August.

This is also a sign of a far bigger problem. The Financial Times article mentioned above also talks about how the global asset managers have suddenly started to focus on the sustainability credentials of their portfolios only because of the increasing demand for ESG investments. The numbers are staggering. For example, the total assets in funds branded sustainable hit $2.24tn in June, up from less than $1tn at the end of March 2020, according to Morningstar. Globally, regulators are now trying to bring asset managers under more stringent regulations to stop misrepresenting and this includes focus on more detailed disclosure requirements.

Figure 1: DWS Stock price over last five days

Source: Google

After the significant crash on Thursday, the stock price of DWS Group has not yet recovered, as can be seen in the chart above. Does this mean that the investors have already assumed that the firm is guilty of making exaggerated claims about the sustainability credentials of its investments? Or, in this case, are the investors staying away to avoid a “what if” kind of scenario? Irrespective of what the market view is, it is clear that the market is ascribing a significant probability to a bad outcome from the regulator’s probe for the asset management firm.

The DWS Group episode is an indication that ESG investing is now turning a full circle for asset management firms. In the recent past, there is a significantly increased shareholder activism on sustainability issues and many asset managers are proactively pushing the companies to do more on ESG integration and ESG reporting. But there was not much accountability on what the asset managers were doing or how they were reporting.

So, while the institutional investors and asset managers are getting more assertive on ESG issues, which is good, there is a significant risk for them. For the global asset management industry in general, this was seen as a stern message from the government authorities that any deliberate attempts to misrepresent or not disclose transparently the data on ESG and sustainability credentials of their portfolio will be dealt with an iron fist and will have consequences. So, be it the companies or with the asset managers, ‘Greenwashing’ is a problem that regulators are acknowledging and addressing.

The dissent is rising

The misrepresentation and outright lying have become a major concern for many people in the ESG ecosystem and they are naturally worried and even disillusioned. For example, Tariq Fancy, who became BlackRock’s first global chief investment officer for sustainable investing in early 2018 was not a big fan of ESG investing. A few months ago, he wrote that sustainable investing is nothing more than “marketing hype”. Tariq is also publishing an insider’s account of his ESG investing experiences called “The Secret Diary of a ‘Sustainable Investor.’” which may open a can of worms.

Recently, there is a very interesting interview he has done with Financial Times titled “The whistleblower who calls ESG a deadly distraction: How an ex-BlackRock executive lost faith in sustainable finance” with Patrick Temple-West and Kristen Talman. Fancy says that ESG is potentially a dangerous placebo, a lot of marketing that answers inconvenient truths with convenient fantasies. “There’s no evidence that ESG investing has done anything…….Even worse, it’s becoming a deadly distraction that slows the kinds of reforms that actually would have a real-world impact.”

And perhaps there are more skeletons in the cupboard and they will keep tumbling out. As sustainability and ESG become more important for investors and asset managers, some companies will always take an easier path to show that they are doing so much but the reality will be different. So, it becomes really difficult for investors to figure out, whom to trust and whether they can believe the claims of asset managers on sustainability or ESG strength of their portfolios.

In another interesting article in The Wall Street Journal by Patricia Kowsmann and Ken Brown titled Fired Executive Says Deutsche Bank’s DWS Overstated Sustainable-Investing Efforts, there are allegations that the Asset management arm painted a rosier-than-reality picture to investors on ESG, according to Desiree Fixler, DWS’s former sustainability chief. Fixler claimed that she had found that the ESG risk management system employed by DWS was highly flawed.

While DWS says that her office didn’t gain expected traction, Fixler on the other hand says she believes that DWS misrepresented its ESG capabilities. It will be debatable as to what was the real cause, performance issues, or gross miscalculation on business potential by DWS. But these allegations are serious, and certainly, these instances impact investor sentiment.

The WSJ article also said that DWS has struggled to define and implement an ESG strategy and the experience underscores the difficulties and pressure that money managers are facing to plant their flag in the hottest corner of the fund market. So, regulators waking up to ‘greenwashing’ claims of asset managers is bad news for offenders. But there are always two sides to a story. The asset managers doing genuine good quality work in the ESG space will be further encouraged to continue on this path.

The underlying message in this episode, the good news and the bad

There are important messages in this DWS episode. The good news, in our view, is that the regulators are now not unsure about the relevance of ESG. They are not debating if sustainability filters are good or bad, are they useful or are they not, and if ESG is a fad that will subside with time. It is a message that conveys that the regulators have perhaps realized that it will be futile to fight the global ‘ESG’ trend. This is a major positive development for ESG advocates as this development indicates that questions can no longer be raised about the legitimacy of ESG today. The ‘whether’ or ‘if’ part has been resolved. ESG is here to stay and the regulators have accepted it.

Once the critics have been silenced on the relevance of ESG, the next part would be ‘how’. The regulators have to focus on how they can level the playing field so that everyone plays by the same rules. They also need to address the common criticism that ESG is just another discovery from Wall Street firms and asset managers to make more money and push the virtues of active investment management. The role of regulators is extremely important in ensuring that the investors get the product they think they are buying and the claims of asset managers on sustainability credentials are proven with diligence and substantiated with hard data

Today, the huge fund flows into ESG investing and the significant rise in AUMs for ESG funds have led to a mad rush and FOMO (fear of missing out) among asset managers. They are hiring ESG talent, building sustainability capabilities inorganically, and engaging with their portfolio companies on how they can do better on their ESG track record. But at the same time, some of the asset managers may also be taking shortcuts. While the end-users or the investors may not always know whether the sustainability credentials of an asset manager are based on real evidence or if they are fabricated, it is the job of the regulators to protect these investors.

There is another significant takeaway that is not that well covered. Wall Street has often been accused of ignoring the pressing problems of this planet and the society and there is a widespread belief that Wall Street firms have not done enough to promote equality and fairness in several different areas. This is often blamed on the hiring practices of the Wall Street firms which always look for that ‘fit’ in the profiles of people they are recruiting. However, some of the ESG talent these firms could be hiring, may not be ready to play by the same rules. The fact that two insiders (from Blackrock and DWS Group), have raised the flag of revolt is proof that the ESG pitch will need real effort and real intent.

How EMAlpha can help

As we have discussed, the changes in perception on ESG track record of a company or an asset manager and reactions from institutional investors have become an important driver of stock prices. In the cases where the volatility is high, it matters even more. The EMAlpha sentiment and ESG scores prove that there is a strong link between stock price performance and these scores. This is very helpful in investment decision making:

  • The news spread has become much faster with social media and the internet. Some of the reports may be difficult to immediately verify and their authenticity may also be questioned, but they still influence the stock price movement. EMAlpha tracks news flow and helps in deciphering their impact on stock price movement.
  • The news flow analysis and their impact assessment are very difficult to track and hence, it is a cumbersome exercise for asset managers if done without optimal help from machines. EMAlpha solves this problem for portfolio managers, at both portfolio and the company level.
  • EMAlpha’s sophisticated AI-ML tools and proprietary analytical methods are based on deep domain expertise and unmatched technological prowess, helping the investors with the most effective and efficient input.
  • The local news flow collection picks up several important issues and the local language along with English news analysis can be tracked for important developments. The potential fallout of such events is usually better predicted using local news analysis.
  • In many global markets, the ownership of some stocks is highly opaque, and this is a big issue. This often makes the stock prices volatile. EMAlpha products pick up these important signals on the institutional investors of a stock.

References

  1. DWS shares fall after US opens probe on sustainability claims https://www.bloomberg.com/news/articles/2021-08-26/dws-shares-fall-after-u-s-opens-probe-on-sustainability-claims (Accessed on 31st August 2021)
  2. US authorities investigating Deutsche Bank’s DWS Group over sustainable investing claims: WSJ https://www.cnbc.com/2021/08/26/us-authorities-investigating-dws-groups-sustainable-investing-claims-wsj.html (Accessed on 31st August 2021)
  3. DWS shares slide after greenwashing claims prompt BaFin investigation, German asset manager accused of misleading investors about its sustainable investing efforts https://www.ft.com/content/0eb64160-9e41-44b6-8550-742a6a4b1022 (Accessed on 31st August 2021)
  4. The whistle-blower who calls ESG a deadly distraction: How an ex-BlackRock executive lost faith in sustainable finance https://amp-ft-com.cdn.ampproject.org/c/s/amp.ft.com/content/4fdc6cdf-7bd6-41bc-b376-2137521e3017 (Accessed on 31st August 2021)
  5. The United Kingdom Government to tighten rules to stop ‘greenwashing’ of electricity tariffs https://www.gov.uk/government/news/government-to-tighten-rules-to-stop-greenwashing-of-electricity-tariffs  (Accessed on 31st August 2021)
  6. UK government to probe retail energy ‘greenwashing’ https://www.ft.com/content/f93485a7-9fa2-47bd-82e6-20414883b215 (Accessed on 31st August 2021)
  7. Efforts to curb energy tariffs ‘greenwashing’ https://www.bbc.com/news/business-58222808 (Accessed on 31st August 2021)
  8. How US and UK regulators are targeting greenwashing https://www.ftadviser.com/regulation/2021/08/13/how-us-and-uk-regulators-are-targeting-greenwashing/ (Accessed on 31st August 2021)
  9. Fired Executive Says Deutsche Bank’s DWS Overstated Sustainable-Investing Efforts https://www.wsj.com/articles/fired-executive-says-deutsche-banks-dws-overstated-sustainable-investing-efforts-11627810380 (Accessed on 31st August 2021)

EMAlpha Products and Services

In most Emerging Markets, information discovery is a major challenge. For example, even if global investors do show interest, how do they solve the problem of timely access to information? The world’s largest capital allocators hold USD 60 trillion and they include GPIF (Japan), GPF (Norway), ADIA (Abu Dhabi), GIC (Singapore) etc. However, only 10% of the capital gets allocated to EMs and ~90% goes to G10. The big hurdle for EMs is: Foreign investors cannot access relevant local information in a timely fashion.

Most market participants and investors from across the world realise that the low rates in G10 makes EM attractive for investors. But, a) Information access is usually a cost and time intensive process for investors, and b) In many EMs, language is a big barrier and because of multiple regional languages, there is a significant delay before news makes it to the mainstream English language. To address these issues, you need solutions like, a) Real time news collection from multiple languages and, b) Instantaneous machine translation and text analytics leading to actionable recommendations for investors.

There are further challenges such as ensuring that companies behave responsibly and that they adopt sustainable business practices. There is a need to ensure that the investors are contributing towards making the world a better place by making investment decisions which reward responsible behaviour of companies. Case in point, ESG (Environmental, Social & Governance) which is increasingly being used as a filter for investment decisions. There are other issues as well such as which data to use and a lack of a standardized framework for evaluation.

Some of these issues are too important to be postponed to a later date and it is in this regard that EMAlpha is making its contribution. EMAlpha has developed a Flexible ESG Framework Management System which is a proprietary technology that makes ESG scores framework agnostic, thus allowing for quick adaptation. In addition, the users decide what matters to them and the EMAlpha system does a classification into E, S, G and more granular categories.

EMAlpha also has solutions for Multilingual data collection and real time targeted information which are based on proprietary processes to collect relevant data across multiple markets. The coverage expands across emerging market equity, currencies and commodities and the work has also been very successful in testing the signals in some key markets for live trading strategies. This is a continuous cycle and a virtuous loop that allows for iterative improvement through AI-human feedback.

With developments in AI and technology in areas like NLP, there are considerable new possibilities to bridge the gap in information between Emerging Markets and the more Developed Markets. This is an area which is turning out to be very exciting because some of the tools mentioned were not available even a couple of years ago. This implies that the evolution in the field will only get faster as time goes on. While the Emerging Markets and the Capital Flow Conundrum is a complex one, there is now much more hope and optimism that with the usage of technology, things will only get better.

At EMAlpha, the ESG team is doing further research on why some issues like Social get more prominence as compared to others like Environmental or Governance issues. To look at specific cases in the context of ESG is a very intense yet interesting exercise and this has been an incredible learning experience for the EMAlpha Research team. The data, information and ratings are a humongous challenge for ESG and it takes time to reach to the depth of the issues as the field is evolving very quickly.

EMAlpha is making a solid contribution in tackling these challenges. EMAlpha has solutions for ESG which are practical, user friendly and although not too simplistic yet easy to use. EMAlpha has developed a Flexible ESG Framework Management System which is a proprietary technology that makes ESG scores framework agnostic, thus allowing for quick adaptation. In addition, the users decide what matters to them and the EMAlpha system does a classification into E, S, G and more granular categories.

We strongly believe that the entire ESG ecosystem requires multiple stakeholders to pull in the right direction in order to make it operational and that will be the most critically determining factor for ESG’s success in making the corporate responsibility actually work. Most importantly, the investors should view ‘E’, ‘S’ and ‘G’ individually and should not confound issues when it comes to the comprehensive ESG evaluation. It is important to understand the right reasons behind ESG investing because this bias could hurt their investment decision making and portfolio performance.

Research Team
EM Alpha LLC

For more EMAlpha Insights on Emerging Markets, please visit https://emalpha.com/insights/. To know how you can use EMAlpha’s unstructured data and ESG (Environmental, Social and Governance) solutions for better investment decisions, please email us at research@emalpha.com.

About EMAlpha:

EMAlpha, a data analytics and investment management firm focused on making Emerging Markets (EMs) more accessible to global investors and unlocking EM investing using machines. EMAlpha’s focus is on Unstructured Data as the EMs are particularly susceptible to swings in news flow driven investor sentiment. EMAlpha works on information discovery and ESG solutions for Investors in Emerging Markets, using AI and NLP tech. Our mission is: “To help increase capital flow, in terms of FDI and FPI, to Emerging Markets by lowering information barriers using AI/NLP”. EMAlpha Products help achieve both alpha and ESG solutions and the idea is to help asset allocators, asset managers, banks and hedge funds along with companies with cost and time efficient access to relevant information. We use thoroughly researched machine learning tools to track evolving sentiment specifically towards EMs and EMAlpha pays special attention to the timely measurement of news sentiment for investors as these markets can be finicky and sentiment can be capricious. Our team members have deep expertise in research and trading in multiple Emerging Markets and EMAlpha’s collaborative approach to combining machine learning tools with a fundamental approach help us understand these markets better.

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