This article first appeared in Wealth, The Edge Malaysia Weekly on February 28, 2022 - March 6, 2022

The simplest way for investors to create a portfolio of stocks and bonds that are compliant with environmental, social and governance (ESG) principles is to utilise the information provided by third-party service providers. 

But it is expensive to subscribe to these services, observes Koh Huat Soon, regional head of research at Maybank Asset Management Sdn Bhd, and it could go against the spirit of ESG investing, which calls for investors to be agents of change through active management.

Technically, one could just pick stocks from the FTSE4Good Bursa Malaysia Index. But there are only 80 constituent stocks to choose from. “So, while it is possible to create a diversified portfolio of Malaysia-only ESG stocks, the potential returns may be compromised due to the small pool of investment choices and liquidity issues, if the portfolio is very large,” he says.

Small-cap stocks are difficult to include due to a lack of documentation and reporting. To build a robust Malaysian ESG portfolio, fund managers will have to go beyond information provided by third-party service providers and do their own evaluations, Koh believes. This, of course, would incur additional costs and resources. 

Another challenge investors would face is choosing from the variety of ESG strategies and interpretations. The taxonomy for ESG-related information is still evolving and companies tend to disclose information differently. 

“What is material and sustainable to one is not sustainable to another, as some believe in negative screening and others in traditional investing that includes ESG principles,” says Anand Pathmakanthan, regional head of equity research at Maybank Investment Banking Group. 

A look at the ESG funds in Malaysia show that many have shariah-compliant screening and rely on the ESG methodology of their external investment advisers. Their product highlights sheets generally do not go into detail about the strategies they employ. 

There are exceptions, however. Areca Dynamic ESG Fund, for instance, uses positive screening while Maybank Global Sustainable Technology Fund focuses on governance, the management team’s commitment to change and issues such as data transparency, under the social pillar.

“Investors may find it challenging to compare the multitude of ESG funds available in the market, given that each fund has a unique investment strategy and focus. Furthermore, domestic SRI funds still have a short investment track record, which makes it harder to assess the credibility of their ESG investment strategy,” says David Ng, deputy managing director and chief investment officer at Affin Hwang Asset Management Bhd (AHAM). 

“Another major risk is greenwashing. With the lack of standardised reporting, ESG offerings in the market can be easily hyped up through effective marketing.”

There is momentum in the market to tackle these issues. For instance, regulators such as Bank Negara Malaysia and the Securities Commission Malaysia are working on a taxonomy and guide to help financial institutions and companies become more sustainable. 

To begin the information-gathering process, investors should read the annual report and sustainability report of companies and ascertain how dedicated the management and board are to their sustainability commitments. 

“It is a particularly positive sign if there is a committee at the board level to drive ESG or sustainability initiatives,” says Anand. 

Summaries of ESG information can be found on websites such as Refinitiv, MSCI, Sustainalytics, Ecovadis, Factset, Arabesque and even Yahoo! Finance. 

“Among the key material indicators to look for is a company’s carbon footprint, its goals on carbon emissions, disclosures on biodiversity, water usage, use of renewable energy, human rights practices, alignment to the UN Sustainable Development Goals and controversies, if there are any, and the resolutions,” he says.

Koh suggests looking at literature provided by standard setters, such as the Sustainability Accounting Standards Board, which identify the material risk factors of various industries for free. “Investors can understand what key ESG risks are applicable to their companies of interest and ask [the management] the right questions about those risks.”

If the stock is a constituent of ESG-related indexes, it is a good indicator. As for bonds, investors should find out whether it is a green or sustainability-linked bond used by companies to transition to low-carbon business models. 

“Also, read analyst reports on the company. There are increasingly more interpretations on ESG or sustainability issues by buy-side and sell-side firms, and these should be scrutinised for more granular details, especially for forward-looking conclusions that cannot be obtained from ESG indexes or external ESG research firms,” says Anand. 

Investors also have to determine their strategy when building the portfolio. The general strategies for ESG investing include negative screening, where certain sectors or companies with low ESG ratings are excluded; positive screening, where the best-in-class are selected; and ESG integration, where ESG factors are considered in the analysis. 

An important point to consider, in Koh and Anand’s opinion, is that the most rewarding investments can sometimes be the modestly rated companies with promising ESG potential. By investing in these companies, investors are indirectly encouraging them to improve their ESG performance. 

A stark example would be the decision to invest in utility companies that are fossil-fuel driven. “In the past decade, European utilities have transformed to be renewable-energy-driven. This has led to significant improvement in their enterprise value, and it could not have been captured with a specific screening,” says Anand.

So, what would make an ESG investment in a fossil-fuel-based company valid? What needs to be seen is “its commitment to decarbonise, its quality of disclosure and commitment, its execution plan and whether it is moving in the right direction for the climate transition”, he says. 

Greenwashed companies are difficult to avoid, but analysts and fund managers can engage with their management and ask them the tough questions. Compared to investors doing it themselves, this is where relying on the expertise of analysts and active fund managers could make a difference. 

“We believe that continued engagement with our investee companies to better align the type of information disclosure and communicating our expected level of ESG best practices has dual benefits. It can improve their business practices and [make them] an attractive company worth investing in,” says Ng. 

AHAM adopts ESG integration as its primary ESG strategy. This means it includes ESG factors in its investment decision-making process that could have a material financial impact, and it applies to all of its internally managed funds. This strategy, in a way, saves ESG-minded investors from having to create a portfolio of ESG-specific funds from scratch. 

“This is a more dynamic approach as it enables us to access a wider investable universe, while driving ESG adoption in the investee companies via regular engagement and dialogue,” says Ng.

Both Maybank and AHAM use third-party ESG rating service providers and companies’ public disclosures, on top of their own research and engagement with investee companies. Interestingly, this could sidestep criticisms about overreliance on ESG rating providers.

“We don’t rely solely on a single source of data precisely due to the lack of comparability and, sometimes, opaqueness in their methodologies,” says Ng. 

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