Cover Story: Resilience amid turmoil

This article first appeared in Personal Wealth, The Edge Malaysia Weekly, on June 15, 2020 - June 21, 2020.
Cover Story: Resilience amid turmoil
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After years of being overshadowed by their conventional counterparts, funds with environmental, social and governance (ESG) strategies are having their day in the sun, having outperformed the wider global stock index in the current market downturn.

As the Covid-19 pandemic weighs down on financial markets, ESG funds — which are inextricably linked to material sustainable characteristics and experience lower volatility — have held up better than conventional funds, say industry experts.

Investment research firm Morningstar found that more than half of ethical and sustainable funds beat the MSCI World Index in March. The stock index fell by 14.5%, with 62% of global ESG-focused large-cap equity funds outperforming the global tracker.

The resilience of ESG funds could be attributed to investors’ belief that these funds are “pandemic-proof”, says Jean-Jacques Barbéris, head of institutional and corporate clients’ coverage at Amundi Asset Management.

In the paper he authored, titled “Day after #3 Covid-19: ESG resilience during the Covid crisis — is green the new gold?”, Barberis says by construction, ESG funds tend to overweight sectors that have weathered the crisis better, such as healthcare and tech, and underweight those that have been most impacted such as transport, energy and materials.

Early evidence suggests that ESG investing is gaining greater relevance in the light of the pandemic, as investors are looking to build more resilient portfolios going forward, says BIMB Investment Management Bhd CEO Najmuddin Mohd Lutfi.

Investors are likely to increasingly consider certain climate-related risks and opportunities in their investment decisions, he adds. The asset management firm launched the world’s first ESG sukuk fund in 2018.

“For corporations and investors, the need to align strategies with a broader purpose that speaks to the needs of society will be the key to growing and building trust. The pandemic has turned the spotlight on human vulnerability and the fact that human safety and the health of the natural environment go hand in hand,” says Najmuddin.

This experience might reinforce existing consumer trends, leading to healthier and more sustainable lifestyles, he continues.

“Environmental priorities are bound to gain greater strategic relevance over time and far-sighted executives will use the current crisis to accelerate decarbonisation and [incorporate] resource-efficiency measures.

“Most important of all, the pandemic has acted as an accelerator for everything digital. Innovation and new business models will enjoy a premium and will give a boost to automation, resource efficiency and decarbonisation, touching all segments of the economy. Digitalisation and better smart data analysis are the fuel that drives ESG investing,” says Najmuddin.

The pandemic underlines the importance of sustainability to the investment industry, concurs Andrew Howard, head of sustainable research at UK-based asset manager Schroders.

“Financial markets no longer exist in isolation from social or environmental challenges. Companies’ fortunes are intrinsically tied to their ability to navigate changes in the societies on which they rely.

“We have long argued that companies don’t operate in a vacuum. Their success reflects their ability to adapt to challenges and trends in the societies to which they belong. That is truer now than ever; social and environmental challenges and investment drivers are increasingly overlapping.

“As a result, environmental and social problems are increasingly clear financial risks, moving up corporate agendas to drive long-term strategy and growth plans. As investors, our ability to examine companies and separate winners from losers has improved as corporate sustainability reporting has become mainstream. This journey will continue; we believe asset managers need to refocus their investment lenses now more than ever,” says Howard.

According to a Morningstar Manager Research report released in April, despite the Covid-19-induced market sell-off in March, the European sustainable funds’ universe — comprising 2,528 open-end funds and exchange-traded funds (ETFs) — continued to attract inflows of €30 billion (about RM145 billion) in the first quarter of the year. Europe has the largest amount of sustainable funds globally.

This contrasts with the €148 billion in outflows suffered by the overall European fund universe, says Morningstar. “This is a testament to the growing awareness among investors of the risks and opportunities arising from climate change. We expect flows into climate-aware funds to continue their upward trajectory in the coming years, supported by significant regulatory developments, including the European Union Action Plan on Sustainable Finance.”

The continued inflows in 1Q2020 speak of the “stickiness” of ESG investments, says Hortense Bioy, director of passive strategies and sustainability research (Europe) at Morningstar.

Investors in sustainable funds are typically driven by their values, invest for the long term and seem to be more willing to ride out periods of bad performance, says Bioy, adding that “they are just more patient”.

“Being invested in sustainable funds and companies that score better on ESG during the Covid-19 sell-off has paid off. Both in the US and Europe, we saw an average outperformance of ESG funds relative to traditional funds. This can be explained by a combination of factors. Firstly, being underweight on less ESG-friendly sectors like oil and gas, and overweight on technology and healthcare helped many ESG-aligned portfolios.

“Traditional factors including quality, minimum volatility and size would also have played a role. Companies that score high on ESG tend to be large well-run businesses that treat their stakeholders well, address their environmental challenges, enjoy more conservative balance sheets and have lower levels of controversies. Many such companies tend to be more resilient during market downturns,” she reiterates.

The economic downturn also did not prevent fund houses in Europe from launching new sustainable funds, albeit markedly

lower than the corresponding quarter last year. A total of 72 new sustainable funds were introduced, down from 120 the year before. Of the 72, a dozen of new offerings were related to the climate change theme.

Morningstar also finds that since last year, asset managers continue to convert existing funds to sustainable investment offerings and incorporate new specific ESG criteria into their investment objectives.

Mandates of the funds are being changed to make ESG the primary focus, says the report. “Repurposing and rebranding are good ways to attract new money to an ailing fund or to bring visibility to a manager’s sustainability efforts.”


The proof of the puddingis in the eating

While there are a variety of ways ESG factors are applied to investment strategies, the crux of it is the combination of the three central pillars and traditional investing matrix to better assess the future financial performance of companies, potentially improve long-term outcomes for investors and positive returns, as well as have a positive impact on society and the environment.

While ESG criteria have proved to be a useful framework to screen investments or assess risks in investment decision-making, industry-wide adoption is still lagging due to the perception that the trade-off for such an investment strategy is relatively weak investment returns.

But the resultant impact of the pandemic could alter the ESG landscape for years to come with a greater focus on social issues in ESG integration as well as the links between climate change and biodiversity loss.

The economic crisis and the consequent market volatility have presented an opportunity to stress test funds aligned more closely with personal values, says Paul Milon, ESG specialist (Asia-Pacific) at BNP Paribas Asset Management.

“ESG funds tend to deliver safer performance with lower downside risks and have a little more defensive characteristic,” says Milon, who is based in Hong Kong.

There has been a heightened interest in how ESG funds have performed against a backdrop of extreme market stress because of the fundamentals that these funds focus on, says Julie Moret, global head of ESG at Franklin Templeton Investments.

“There have been record flows into sustainability-themed funds with ESG indices performing better than their broad-based counterparts. These headlines alone miss a more nuanced fundamental insight, which is that ESG information is an additional signal for quality companies — those companies that are well run, managing well not just their financial capital but also their environmental externalities and stakeholders.”

Eugenia Koh, head of sustainable investing and engagement strategy, private bank and wealth management at Standard Chartered Bank, points out that ESG funds also outperformed “sin stocks” in Malaysia at the height of the pandemic in February and March.

“Such stocks have typically been resilient in past economic slowdowns but the coronavirus and lockdowns around the world have significantly impacted the alcohol and gambling sectors.

“ESG funds have benefited from owning shares of companies with strong business models. [These models], through their sound management of environmental and social issues, have a degree of resilience that helps in times of crises.”

Citing an internal research that compared over 10,000 funds between 2004 and 2018, Koh says sustainable funds had 20% less downside risk than traditional funds, and these funds were more resilient in years of turbulent markets such as 2008, 2009, 2015 and 2018.

As a bear market increases stress on earnings, it forces analysts and investors to understand the underlying drivers of value creation such as corporate governance structures, employee and customer loyalty and operational efficiency, which are among the factors considered in ESG evaluation, says Koh.

Katherine Davidson, portfolio manager of global and international equities at Schroders, says it has been long argued that sustainable companies should have lower declines due to lower incidence of controversies and occupational mishaps; greater loyalty from customers, employees and even shareholders; and often more conservative balance sheets.

“The current crisis provides an unfortunate opportunity to test these hypotheses. Thus far, the evidence seems encouraging. As much as we are sceptical of passive ESG funds, it is interesting to see that the MSCI ESG Leaders indices have outperformed their mainstream counterparts in most geographies, albeit modestly in most instances.”


Other reasons for the outperformance

It is undeniable that the downturn in the energy sector as oil prices tumbled after Saudi Arabia launched an aggressive price war against Russia in early March played a role in the performance of ESG funds.

This is because almost all ESG funds avoid or negatively screen against oil stocks, meaning their performance have not been affected by the plummeting share price.

Drawing similarities, Lim Tze Cheng, head of research at EquitiesTracker Holdings Bhd, points out that shariah funds — which are considered socially responsible investments — are not as greatly impacted as conventional investments because the funds avoid highly volatile stocks such as banking, many of which are not considered shariah-compliant.

The most likely reason for the outperformance of ESG funds appears to be what they are not holding, opines Lim. “The ESG funds, like shariah funds, have a strict

selection criteria. ESG funds avoid stocks like oil and shariah funds avoid sectors such as gaming, banks as well as [other] sin stocks.

“In this crisis, banking stocks have been badly affected and consequently, conventional funds that hold on to these stocks have suffered. This doesn’t mean that shariah stocks are entirely resilient — it is because they have a higher weightage in defensive sectors,” argues Lim.

Nevertheless, while the oil slump has contributed to ESG funds’ admirable performance despite the outbreak, which has wrecked global capital markets and economies, it is certainly not the only reason, finds a recent study by BlackRock Sustainable Investing (BSI).

Although sustainable funds are relatively underweighted in traditional energy companies, BSI states that the outperformance has instead been driven by a range of material sustainability characteristics, including job satisfaction of employees, the strength of customer relations, or the effectiveness of a company’s board.

According to BlackRock’s study titled “Sustainable Investing: Resilience amid Uncertainty”, the resilience of sustainable investing does not only apply to the equities universe but also extends to fixed income.

“We also posit that sustainable characteristics should be priced in the bond market: if our sustainability assessment helps indicate positive long-term growth prospects for an issuer’s equity — and therefore its financial solvency — it should also help predict how likely that issuer is to pay back its debt. As a result, we expect to see credit return differences between top and bottom-ranked firms over time but especially in market crashes,” it states.

However, finding decent income and maintaining a clear conscience is a growing challenge for investors, says Lesley-Ann Morgan, head of multi-asset strategy at Schroders.

“Investors don’t want to invest in companies and countries that they perceive to be causing harm. Energy and tobacco companies, for example, offer some of the highest yields in the market. Utility companies do too, and they are some of the biggest users of fossil fuels. This has created a perception to some extent that being an ESG investor is becoming incompatible with being an income investor. We don’t think that’s true,” she continues.

Morgan says by opting for a multi-asset approach, investors have access to strategies that target a better sustainable outcome such as thematic investments like renewable energy equities or green bonds.

Another reason for the pivot towards ESG funds may come from segregation of the two markets, says Amundi’s Barbéris. Investors with different investment characteristics and strategies can invest separately in the ESG and conventional ETF market segments.

“Investors with shorter horizons and higher liquidity needs could position themselves in conventional equity ETFs, with larger traded volumes and higher liquidity, explaining massive disinvestment from these funds during crises, while investors with longer horizons could remain invested in ESG funds,” he points out.

It is possible that investors have shown greater loyalty to their ESG investments, says Barbéris. “An assumption consistent with this behaviour is that investors derive positive utility from the simple act of investing responsibly, which can compensate for the disutility associated with negative performance, and lead them to keep their investments during crises.”

However, even if loyalty is not the primary reason, he says ESG funds may have benefited from investor preference and played the role of safe havens within equity markets.

“Such conventional preferences usually manifest themselves during crises in terms of capital shifts between asset classes but also within each asset class among different market segments. For example, within government bonds, between on-the-run and off-the-run securities, or between nominal and inflation-indexed bonds.

“In the Covid-19 crisis — which clearly has strong social and environmental implications — it seems investors perceived a strong ESG performance as a defensive characteristic,” says Barbéris.


Sustainable investing set to surge

Responding to concerns that the economic fallout from the pandemic is likely to derail ESG funds’ recent momentum, BNP Paribas’ Milon says long-term challenges such as climate change and demographic changes that ESG investors focus on are here to stay despite the virus outbreak.

What’s more, the pandemic is a clarion call for heightened response to solve social and environmental issues urgently and ought to galvanise support for more private-source financing.

In an article commemorating Earth Day, Milon says since 1970, the world population has more than doubled to 7.8 billion people, putting increasing pressure on environmental systems. “On average today, each person produces 21% more CO, uses 47% more fuel and consumes 65% more meat than in 1970. Per capita, plastic production increased by 447% to reach a staggering 4.9 tonnes in 2018.

“If anything, this crisis reinforces the fact that sustainable development is the way forward,” he stresses.

Milon says these challenges also represent a growing opportunity to invest in companies offering innovative, market-leading solutions in areas such as renewable energy and energy efficiency, water technology, sustainable food and agriculture, waste and resource recovery, and a circular economy.

Even though the full impact of the pandemic has yet to materialise, what has been evident is the immediate impact on people’s lives and the dislocation in markets, adds Franklin Templeton’s Moret.

Moving forward, she says the crisis has served to accelerate existing ESG themes and sustained over the long term. These themes include a shift towards a wider stakeholder-oriented

model, a change in focus towards human capital matters and near-term focus on the “S” in ESG, which shows that social factors will not eclipse the momentum on environmental tailwinds, she adds.

Standard Chartered’s Koh also supports the view that Covid-19 has amplified the investment materiality of ESG factors, especially its social component. “The pandemic has had a significant impact on global supply chains and the risks around this have increased. Investors are therefore looking at whether companies have a well-diversified supply chain and whether there are strong policies around engagement with key suppliers. In terms of workplace benefits, the reputations of companies and employee loyalty are being impacted by the way health and safety is being looked at and managed.

“Investors will continue to monitor the materiality of ESG factors as they consider diversifying their portfolios to include some ESG opportunities.”

Amundi’s Barbéris says the Covid-19 crisis has moved social considerations back to the forefront of ESG. “Companies’ decisions affecting workers, in particular, the health and social protection of employees, telework or unemployment policies, as well as providing production chains to produce medical equipment, have become increasingly important.

“This is illustrated, for example, by the reactions of Amazon’s share price to the controversies over the working conditions of its employees during the crisis, but also by the numerous press articles on Covid-19-related corporate social responsibility policies,” he says.

Some firms, especially in high-tech industries, have adapted rapidly to social-distancing requirements, for instance by making extensive use of teleworking, while others could not owing to the nature of their business that requires close contact with customers such as those in sectors like food catering, travel and tourism, says Barbéris.

“This heterogeneity in firms’ conditions is visible in the diverging stock price performance of companies. As shown by recent academic research, social-distancing resilient firms (those having a high fraction of employees working at home, and thus having firms’ operations more compatible with social-distancing measures) outperformed non-resilient firms by approximately 10% between Feb 24 and March 20,” says Marie Briere, head of investor research centre at Amundi and affiliate professor at Paris Dauphine University.

“Interestingly, a similar outperformance of social-distancing resilient firms was also visible before the pandemic crisis since 2014. It is likely that financial markets will continue to price this risk in the coming months,” she adds.

Barbéris stresses that companies with environmental and climatic action are better valued by investors. “It is becoming impossible to argue that investors do not have to worry about the environmental externalities generated by companies. The Covid-19 situation reminds us that natural disasters can happen suddenly and unexpectedly and that we are more vulnerable than we previously would have imagined.

“It is difficult to predict today if ESG issues will continue to be a priority for investors, considering the major economic and financial problems we are going to face in the next few years. But our analysis suggests that investors’ taste for ESG has not decreased during this crisis — quite the opposite, in fact. In this sense, we hope that the recent trends we have observed on ESG assets will continue and amplify in the months to come,” he says.


How Malaysian ESG funds have performed

The coronavirus pandemic triggered a severe stock market crash but sustainability funds have outperformed other funds since the crisis began.

Local funds that subscribe to environmental, social and governance (ESG) metrics and strategies showed positive returns, and in some cases, outperformed the average returns in their respective categories based on the Lipper fund performance table in the three months ended May 29.

The Interpac Social Enterprise and Responsibility fund is a wholesale fund that has been around since 2017. According to Lipper data, it saw a return of 12.41% over the three months ended May 29. The fund invests a minimum 70% of its net asset value (NAV) in equities and equity-related securities listed in the local and Asia-Pacific markets. The fund excludes companies involved in gaming, alcohol, tobacco and other businesses regarded as vice and also has a flexible asset allocation to invest in money market instruments.

BIMB Investment Management Bhd, which explicitly focuses on ESG and shariah-centred equities and fixed income, has a number of unit trust funds locally. One of them is the BIMB-Arabesque Malaysia Shariah-ESG Equity fund that saw a return of 7.59% between Feb 29 and May 29. In its top five holdings (as at April 30) are Merck & Co Inc, Anhui Conch Cement Co Ltd, Roche Holding Ltd Genusssch, China Resources Cement Holdings Ltd and TIME dotCom Bhd.

The Saturna ICD Global Sustainable Fund offers investors an opportunity to own a global shariah-compliant equity portfolio. In the last three months ending May 29, it returned 5.59%, according to Lipper data. The fund has a heavy weightage in technology, healthcare and consumer discretionary and staples sectors. As at March this year, it held equities of companies such as Intel Inc, Johnson & Johnson, L’Oréal, Edwards Lifesciences and Hikma Pharmaceuticals.

The Public e-Islamic Sustainable Millennial Fund, which was launched in November last year, aims to achieve capital growth over the long term by investing 75% to 98% of its NAV in shariah-compliant stocks of companies, which incorporate sustainability considerations in their business practices, primarily in the environmental and social aspects. In the last three months (as at May 29), it saw a return of 10.67%.