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Seven Questions Every Investment Manager Needs to Ask on ESG

Synopsis: EMAlpha has recently picked up some really fascinating developments in the ESG market space. The usefulness of ESG has come under the microscope of late as both practitioners and regulators ask deeper questions. There are concerns, primarily around implementation and practical utility. For example: Are the companies reporting truthfully? Do they really want to change for better or are they just paying lip service and indulging in window dressing? Is the ESG based investment strategy really superior and is there a long enough track record to claim that ESG filter will outperform other decision-making filters? Even if an investment manager is serious about using the inputs for their investment decision making, how do they get the data which is reliable and comparable for their portfolio? How do investment managers ensure that they are on top of important developments, including news flow in local languages? The situation gets more complicated because the ESG space is evolving very fast and there are several areas of serious disagreements. But that does not mean that we can’t make progress. There are ways to resolve these issues. The investment managers need to be more circumspect because as ESG becomes more popular as an investment filter, there will be more widespread problems related with misrepresentations and even outright frauds. As the stakes go higher, the incentive to cheat will also increase. Therefore the investment manager will need to go beyond the official data. They have to look at more unstructured data and see whether the conclusions are any different. The organizations will also need to support this endeavour so that the investment managers can afford to be more patient and dedicate more resources and a fair budget to ESG related activities.

Investment Management Industry pivots to ESG, but that is passé

For someone actively tracking the developments in the ESG (Environmental, Social and Governance) space, it is not really news that the popularity of ESG as a filter for Investment Management Industry has grown exponentially. The value of global assets applying environmental, social and governance parameters to drive their investment decisions has almost doubled over four years and more than tripled over eight years, to reach a level which was in excess of $40 trillion in 2020. There are other estimates as well which could have a slight variation but there is almost a uniform consensus that ESG is becoming increasingly important for the Asset Management Industry. The growth of AUMs under ESG filter is faster than the broader industry AUM growth and there are also structural factors to support the assertion that this will continue in the foreseeable future.

The Coronavirus pandemic may have been a trigger but the change was apparent over the last many years. At EMAlpha, we regularly track the global developments in the ESG space and it comes as a surprise as to how rapidly the space is moving. After the machines do their job in the first round of screening, our ESG team on a weekly basis analyses some of the more important events which have more medium to long term consequences and we are amazed at how fast the ecosystem has evolved and continues to do so. There are reports on new and better regulations, strong push for more proactive Government initiative, increased receptiveness of companies and more institutional money managers supporting the need for responsible behaviour from companies. But all of this does not mean that the road is smooth for ESG to become a universally acceptable way of making investment decisions.

More voices speaking about the pitfalls, either in the concept or in the process

While 2020 was more about how ESG became prominent as a topic of debate in the mainstream media and how investors, companies and fund managers started to accept the inevitability of Sustainability concepts becoming an essential filter for investment decisions, we think that this development was only natural. That’s because when the entire world was struggling with the impact of Covid-19 pandemic, it was difficult to argue against the need for companies to behave more responsibly and being rewarded more for the same. But as the circumstances change to normalcy and as the world returns to more ‘business-as-usual’ approach, the ESG and Sustainability topic have also started to attract more scrutiny. There are important issues which some really important people have been talking about;

  1. Tariq Fancy, the former chief investment officer for sustainable investing at BlackRock Inc., the world’s biggest asset manager, raised serious concerns on Greenwashing. He criticised the industry’s duplicity and wrote that sustainable investing boils down to little more than marketing hype and PR spin from the investment community.
    Fancy says that the Wall Street is “greenwashing the public with deadly distraction in sustainable investing practices” instead of getting to the heart of the issue. (‘Wall Street Is Greenwashing Finance’, Says Former BlackRock Sustainable Investing CIO, https://www.greenqueen.com.hk/wall-street-greenwashing-finance-says-former-blackrock-sustainable-investing-cio/
  2. Billionaire activist investor Bill Ackman, the CEO of the $13 billion hedge fund Pershing Square Capital thinks that capitalism is “the most powerful potential source” for solving society’s biggest challenges — and ESG investing is helping in bringing about that change. However, Ackman also said they don’t have a uniform set of factors when evaluating ESG, but instead, the due diligence process depends on the company and the sector. (Ackman says capitalism is ‘the most powerful potential source’ for solving society’s problems, touts ESG investing, https://finance.yahoo.com/news/bill-ackman-on-capitalism-and-esg-investing-163654033.html )
  3. The market regulator for India, the Securities and Exchange Board of India (SEBI), is a Government of India Institution, responsible for ethical and fair markets. Recently, SEBI’s chairman Ajay Tyagi admitted that the regulator has failed to ensure that independent directors not act under the influence of promoters or owners, despite several attempts to make certain that the rights of minority shareholders are protected. This is a clear admission on the regulator’s part that the Corporate Governance standards are not where they should be and there is a long way to go in ensuring the independence of independent directors and making their role more effective and meaningful. (Despite efforts, independent directors not entirely independent: SEBI chief, https://www.thehindubusinessline.com/companies/despite-efforts-independent-directors-not-entirely-independent-sebi-chief/article34256886.ece )
  4. Envestnet PMC’s co-CIO, Dana D’Auria says that the investment advisors are increasingly pitching ESG portfolios and investments on their potential to offer excess financial returns, or alpha, or market returns with less risk, a “smart” or “strategic” beta. But thus far the evidence that ESG portfolios can offer alpha or a better form of beta remains unproven, making a more traditional moral rationale for ESG investing the safer argument from advisors. The best reason for advisors to pivot towards ESG investing is not the promise of offering alpha or beta to clients, but because certain clients demand that their portfolios be brought in line with moral or political beliefs, said D’Auria. (ESG Investing’s Return Premium Still Unproven, Envestnet Exec Says, https://www.fa-mag.com/news/why-esg-investing-can-t-yet-be-about-adding-alpha-or-better-beta-to-portfolios-61347.html )

The main ESG issues that worry Investment Managers

On the basis of what EMAlpha-AI has picked up, we think there is absolutely no hesitation regarding ESG being a good aspect, at least in theory. Almost everyone agrees on that. But there are concerns, primarily hovering around factors regarding implementation and practical utility. These are as follows:

  1.  Are the companies reporting truthfully? Do they really want to change for better or are they just paying lip service and indulging in window dressing? More importantly, how to figure it out?
  2. Is the ESG based investment strategy really superior and is there a long enough track record to claim that ESG filter will outperform other decision-making filters? Or it is just a coincidence for those who claim so?
  3. Even if an investment manager is serious about using the inputs for their investment decision making, how do they get the data which is reliable and comparable for their portfolio?
  4. Since there are no universally acceptable standards in ESG, how do the investment managers ensure that their internal processes keep pace with the evolving landscape?
  5. How do investment managers ensure that they are on top of important developments including news flow in local languages?
  6. Are there companies which focus too much on their areas of strength to get an acceptable overall score in their ESG evaluation and in the process misrepresent their track record in others areas?
  7. Which ESG scoring framework should the investment managers employ and how much should they really trust them? Are readymade solutions any good?

How to resolve these issues?

First, let us admit upfront that there are several grey areas in the ESG space where there is not enough clarity on how these questions can be answered satisfactorily. The ESG space is evolving very fast and there are several areas of serious disagreements. But that does not mean that we can’t make progress. In relation to the concerns we have raised above, the following are some remedies we would like to state:

  1. There are many companies which are making genuine attempts to get better and address the issues they might have on Environmental, Social and Governance sectors. But the investment managers need to be careful and must try to look back into the past track record, as far back as possible. The company’s DNA doesn’t change that easily unless there is a change in ownership and senior management. If the issues relate to Governance, it would be difficult to believe the rest. They should also review how the company’s reporting has changed and whether it tries too hard to talk about the themes which are in flavour instead of following a more consistent approach. These are some of the red flags one should be wary of.
  2. We admit that there is not enough data and no matter what the supporters or detractors claim, there is not enough history to draw any worthwhile conclusions about the superiority of returns, either with ESG or without ESG. Nevertheless, we think that the investment managers should approach this problem a little differently. If there is no evidence that using ESG filter will lead to a compromise on returns, there is absolutely no reason why ESG should not be used. If the intent is doing good, equivalent returns should not be a problem. The problem arises only when the returns are inferior with ESG and that has not been the case so far.
  3. When an investment manager wants to use the ESG inputs for their investment decision making, they should be ready to toil a little more to figure out what works for them. The company reports and disclosures are useful but not sufficient enough. We are also concerned that as ESG gets more popular as an investment filter for fund managers, there will be more widespread problems related with misrepresentations and even outright frauds. As the stakes go higher, the incentive to cheat will also increase. So, the investment manager will need to go beyond the official data. They have to look at more unstructured data and see if the conclusions are any different.
  4. Unfortunately, the readymade solutions will only have a limited utility and the internal processes will have to be evaluated and revamped to keep pace with an evolving ESG landscape. The investment managers will need to have clear ideas on which are the areas to focus in terms of sectors and geographies and how should they approach them over the short to medium term. The investment managers should also think and decide clearly on which ESG parameters matter for them the most and what are the goals they intend to achieve through this ESG investment filter? They then need to create an internal ecosystem within their organization and regularly evaluate it for effectiveness.
  5. Investment managers need to ensure that they don’t miss out on the important developments and not limit themselves to what they are being fed through official sources. The importance of ‘channel checks’ and ‘on the ground research’ is immense and to achieve success, this has to be done independently and regularly by investment managers. The organizations also need to support this endeavour of fund managers by allocating dedicated internal or external resources and a separate fund for this activity. The investment managers also need to scan the market for solutions which offer services through which they can track the local language news.
  6. Companies cherry picking what could be their best bet to achieve an overall acceptable and good score, is emerging as a major area of concern. To make up for their weakness in certain areas, companies ensure that they get extremely good scores in certain other areas. The investment managers need to be very careful on these issues. In these situations, the investment managers should look at the separate scores for E (Environmental), S (Social) and G (Governance). This will be very useful in seeing how the companies are doing in their separate verticals. The investment managers should also look at this data on a time series and see if the priorities have changed for a company over time, just to make it look more appealing.
  7. The suitability of a particular ESG scoring framework matters and will be useful for investment managers. Usually, the opaqueness of a scoring methodology and ‘black box’ approach are the major challenges that the investment managers will encounter and they will struggle to even understand what the scores mean. The idea is to not get influenced too much by big, fancy numbers such as how many stocks are under coverage, how many parameters a scoring framework employs and how the investment performance has been using this framework. These are of limited utility and for optimal usage, the investment managers should be more focused on developing a better understanding on how the scores are arrived at and whether the scoring methods are aligned with the objectives of the fund manager.

How EMAlpha can help in some of these situations?

The rapid developments in ESG space and conflicting viewpoints on what is the best way forward for investment managers is often a very confusing problem. But, EMAlpha’s ESG offering is centred around addressing some of these very critical issues in the following ways;

  1. ESG is a strong driver for improvement in investor perception. But it is the composition that makes the big difference and as such all the three parameters that make up ESG need to be evaluated separately. The EMAlpha algorithms provide separate scores for E, S and G so that an investor can review the sectoral performance more transparently.
  2. A key feature of EMAlpha’s NLP algorithms in ESG space is that the attribution analysis is fairly simple and straight forward. Investors need to be very careful in differentiating between actual improvement and progress which is balanced vs. fake and dishonest attempts like ‘greenwashing’ and disproportionate focus on one particular part in an unbalanced way.
  3. The ESG is as much about intent as it is about execution. For this balanced evaluation, having an understanding of the local factors is very crucial. A good ESG track record (probably more driven by excellent performance in E and/or S) may hide serious Governance related risks and the investors can only ignore them at their own peril. EMAlpha analysis meticulously incorporates this critical part of the ESG evaluation jigsaw puzzle.
  4. Because the local news flow collection picks up issues earlier than the English media, it is very useful to do regular analysis of social media (such as Reddit feed) and use it as input before taking an investment decision. It is here that EMAlpha’s analysis of unstructured data becomes a much-needed tool for investors to spot these trends quickly.
  5. The local language along with English news analysis can be tracked for the companies experiencing ESG related issues. Considering the sensitivities involved, especially when institutional investors have invested in the stock, these issues could escalate quickly, thus impacting the stock price performance. The unstructured data analysis in other geographies can also be used to assess potential impact on larger companies.
  6. Predicting the behaviour of large institutional investors on the basis of their public position on certain issues can help forecast the stock price impact. This is one of the key features of EMAlpha product as it combines technology with domain expertise. The analysis provided by EMAlpha is useful in picking up the signals when the views change for institutional investors.

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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