ESG: More Than Just a Number

ESG in EMD: Making or Breaking the Sovereigns

The Covid-19 pandemic has exposed long-standing social tensions and governance challenges which lurked below the surface in many emerging markets. In Ecuador, for example, social unrest and violent protests have made implementing reforms a challenge even before the global pandemic sent oil prices plunging. In Turkey, governance concerns and unorthodox policies warn of heightened capital control risks, as debt rollover becomes less of a given in a world of increased supply.

As these countries proved less equipped to handle macro shocks to the economy, many of these environmental, social and governance (‘ESG’) tensions finally erupted, tipping the delicate balance between fragile debt-laden balance sheets and global QE-induced liquidity in favour of the former.

Given the nascent nature of emerging markets (‘EM’) and the broader spectrum of countries at differing stages of development, ESG considerations can provide a valuable insight when determining the creditworthiness of an EM sovereign. In some cases, ESG factors can serve as a warning sign of latent risks that may make or break an EM sovereign’s ability or willingness to service its debt.

As such, we believe that investors’ emerging-market debt processes can be improved by integrating ESG analysis into their decision making. Indeed, we believe it is of utmost importance to adhere to a disciplined investment process, focusing on fundamentals, valuations and positioning when navigating increasing macro and idiosyncratic risks within emerging markets. In our view, analysis of the fundamentals incorporates ESG factors as part of a holistic approach to investing, advocating for an integration approach rather than an exclusionary one.

Don’t Just Check the Box, Think Outside of It

Investor demand for ESG products, in conjunction with an evolving regulatory landscape promoting the cause, has led to a surge in ESG constrained/rebalanced benchmarks. Typically, such benchmarks exclude the weakest ESG scoring issuers, while rebalancing the weights in favour of the higher scoring issuers. Benchmarks are probably the simplest way to check the box and tout an ESG-friendly investment approach. However, a better approach may be to think outside the box and integrate ESG into the investment process without narrowing the scope of the universe or inflating the weights of select issuers disproportionate to their outstanding issuance. We believe that investors could benefit from an approach which recognises the importance of ESG factors in assessing the risk profile of an issuer, while also maximising return potential. Namely, it would enable an investor to be forward-looking in considering evolving ESG scores and trends (i.e. low-scoring issuers that may be on an upward trajectory), while also taking advantage of market dislocations rather than chasing potentially expensive assets (i.e. avoiding herd mentality and overcrowding among the high-scoring issuers).

Those who advocate for ESG benchmarks typically do so on the premise that it does not come at a sacrifice to returns, and highlight that performance is typically in line or slightly better than the unconstrained benchmark. However, the expected return of an active manager is a function not just of the beta or the underlying benchmark, but also of alpha. In our view, alpha generation and country selection are key to maximising emerging-market debt return potential, particularly in a world of rising defaults and where yield does not necessarily translate into return. The shortcoming we find with simply managing against an ESG benchmark is that it constrains and rebalances the universe based on a single factor (i.e. ESG), limits diversification and reduces the alpha opportunity set in the process. If the objective is to maximise risk-adjusted returns, ESG risks should not be viewed in a vacuum but in conjunction with the broader fundamentals, valuations and positioning (the degree of crowding, as an indicator of whether there is any marginal buyer/seller left).

Figure 1 shows a comparison of historically available returns for the JP Morgan ESG EMBI (‘JESG EMBI’), along with returns for the full, unconstrained JP Morgan EMBIG Diversified (‘EMBIG Div’). JESG EMBI’s performance was similar to EMBIG Div and even marginally outperformed over the period. However, a closer look at the data reveals that much of the outperformance of the JESG EMBI can be explained by its omission of Venezuela, rather than as a result of any near-term predictive power that a standalone ESG score may have on performance. Venezuela is an example of a low-scoring ESG country (omitted from the JESG EMBI) that ultimately defaulted and became subject to OFAC¹ sanctions. However, there were also many cases of low-scoring ESG countries that outperformed both the EMBIG Div and the JESG EMBI during the period.

Figures 2a and 2b are a comparison of the performance of the bottom 10 ESG-scored EMBIG countries relative to the top 10 ESG-scored EMBIG countries since the start of the data series as of 31 December, 2012. In the case of Venezuela in particular, there were red flags and governance concerns well in advance of the actual default and sanctions. For example, the US had threatened to add Venezuela to its list of state sponsors of terrorism months before OFAC finally sanctioned the country and its monopoly government-owned oil and gas company, PDVSA. An ESG-integrated approach would enable an active manager to maximise alpha by heeding to these warning signs to avert defaults/sanctions in a country like Venezuela, without tying their hands from generating alpha in other low-scoring ESG scores that might be on an improving fundamental trajectory or at less risk of default.

Figure 1. JPM ESG EMBI Versus EMBIG Div Benchmark

Period	JESG EMBI Return	EMBIG Div Return	EMBIG Div ex-Venezuela Return
2013	-5.0%	-5.3%	-5.0%
2014	8.8%	7.4%	8.5%
2015	1.1%	1.2%	0.9%
2016	8.8%	10.2%	9.4%
2017	10.7%	10.3 %	11.1%
2018	-3.8%	-4.3%	-4.1%
2019	15.9%	15.0%	15.5%
YTD Oct 2020	0.3%	-0.5%	-0.5%
Cumulative Return	40.8%	37.0%	39.4%
Annualised Return	4.5%	4.1%	4.3%

Source: Bloomberg, Man GLG; as of 30 October 2020.

Figure 2a. Bottom 10 ESG Scored EMBIG Countries

Country	JPM ESG score (as of 31 Dec 2012)	Total Return (31 Dec 2012 - 30 Oct 2020)	Annualised Return
Pakistan	11.8	93.9%	8.8%
Cote D'Ivoire	10.1	88.3%	8.4%
Guatemala	20.8	64.0%	6.5%
Iraq	8.3	55.3%	5.8%
Vietnam	29.5	55.0%	5.8%
Angola	20.1	40.8%	4.5%
Nigeria	9.7	39.8%	4.4%
China	29.6	38.8%	4.3%
Jordan	28.5	22.1%	2.6%
Venezuela	19.8	-82.4%	-19.9%
Average	18.8	41.6%	4.5%
Average ex-Venezuela	18.7	55.3%	5.8%

Source: Bloomberg, Man GLG; as of 30 October 2020.

Figure 2b. Top 10 ESG Scored EMBIG Countries

Country	JPM ESG score (as of 31 Dec 2012)	Total Return (31 Dec 2012 - 30 Oct 2020)	Annualised Return
Jamaica	68.9	131.3%	11.3%
Belize	71.7	88.0%	8.4%
Hungary	75.9	64.7%	6.6%
Uruguay	77.7	58.4%	6.0%
Romania	66.4	53.8%	5.6%
Croatia	63.3	52.3%	5.5%
Chile	74.7	47.2%	5.1%
Poland	79.6	32.9%	3.7%
Lithuania	83.4	29.5%	3.4%
Costa Rica	69.7	22.5%	2.6%
Average	73.1	58.1%	6.0%

Source: Bloomberg, Man GLG; as of 30 October 2020.

Many investors may also wish to include ethical exclusions in their ESG-integrated allocations. Man Group’s Responsible Investing framework prevents investments in companies across four key areas: (1) controversial arms and munitions; (2) nuclear weapons; (3) tobacco; and (4) production of coal and coal-based energy if it represents more than 50% of revenues. However, beyond these baseline ESG requirements, the danger of applying too strict an exclusionary approach to emerging-market sovereigns is that ESG issues are often not as binary as implied by a score taken in isolation.

The relevance of ESG factors to the creditworthiness of a country often depends not only on the specific factor, but also how it relates to and affects the overall fundamentals and debt dynamics of a specific country. ESG scores can vary across emerging markets depending on the factors that are incorporated by different ESG data providers and how they are weighted. As such, for widely distributed mutual funds, our preferred approach focuses on ESG integration rather than exclusion, with the goal of maximising alpha and risk-adjusted returns. This offers a more consistent approach that integrates ESG into the investment process, while considering both quantitative and qualitative factors in conjunction with the broader fundamentals and valuations.

More Than Just a Number

Our view is that an investment process should start with country comparisons of the fundamentals by assessing macro-economic variables that have historically had a high correlation with a country’s ability to pay back its debt. Calculating standardised scores (z-scores) for each of these variables across the EM universe allows for cross-country comparisons relative to the average on that indicator. Then, aggregating the results on the individual variables into a weighted average country score enables the ranking of countries.

This initial ranking of the countries allows the screening for outliers on either the rich, or cheap, side. While a quantitative approach can be used to filter down the universe for potential opportunities, we believe a deep-dive analysis of the outliers should include qualitative factors as well to determine if there is a shift in fundamentals that is not getting captured in the sovereign score model, or a potential investment opportunity due to a market mispricing.

At a more granular level, a combination of quantitative and qualitative considerations can be applied when assessing the individual variables. The individual factors on which different EM countries score well or poorly can vary. Indeed, high-ESG scoring countries may mask underlying issues at the individual factor levels. Initial screenings often require a deeper analysis that goes beyond just a single score.

For example, a country like South Africa has a higher-than-average JPM ESG score relative to its EMBIG universe peers and scores relatively well on Worldwide Governance Indicators given historically strong institutional checks and balances. However, the key risk plaguing South Africa is a high public debt burden and significant contingent liabilities related to state-owned enterprises. Debt sustainability concerns were further exacerbated this year by the Covid-19 pandemic and a surge in the fiscal deficit amidst ongoing growth challenges. For the financial year ending March 2021, gross debt/GDP is expected to surge from 63% to 82% and continue its upward trajectory in the coming years. In the case of South Africa, significant expenditure cuts, particularly with regards to wages in the public sector, will be required to reign in the fiscal deficit and stabilise debt. From an ESG perspective, the pressure point is likely to be driven by social factors that serve as a hindrance to needed reforms.

A spider chart for social factors shows that high unemployment is a weak spot for South Africa (Figure 3). Negotiations with labour unions already make expenditure cuts on the wage side challenging, while an unemployment rate of more than 30% further complicates the situation for the government. With regards to the ‘E’, a low score for carbon intensity is not necessarily a signal of a lack of willingness to promote sustainable energy – South Africa was a signatory to the Paris Agreement on Climate Change – rather the difficulty for a state-owned, monopoly coal-powered utility company to make a timely shift towards a more sustainable foundation. To best understand the credit trajectory of a country, both a quantitative and qualitative assessment of the fundamentals is warranted. In our view, this is best supported by an integrated approach to ESG, and one that looks beyond just a single score.

Figure 3. South Africa – Assessing ESG in the Context of Overall Fundamentals

Source: Man GLG; as of 19 November 2020.

Marrying Fundamentals With Valuations

Volatility within EM can also pave the way for opportunity. The ability to remain nimble, rather than being constrained by a static ESG score or any single factor, enables an active manager to respond not just to changes in the fundamental trajectory, but also valuations.

For example, in October 2019, an attempt to end fuel subsidies in Ecuador triggered social unrest and violent protests, serving as a warning sign that trouble was brewing in the country even before it was hit by a global pandemic and a plunge in oil prices in early 2020. Ecuador ultimately ended up defaulting, but volatility in valuations provided investors with opportunities to generate alpha. An active manager could have generated alpha by avoiding the bonds at close to par when risks were not appropriately priced, but would have missed significant upside by ignoring a shift in valuations that better priced default risks when bonds fell into the USD30s (Figure 4). Focusing solely on ESG factors would have little near-term explanatory power for returns if taken out of the context of fundamentals and valuations. As such, a sovereign score model should consider ESG factors that may serve as warning signs for larger credit concerns, but also marry fundamentals with valuations. This enables investors to maximise alpha by screening for mispricings, or divorces between the two in the market.

Figure 4. JPM EMBIG Ecuador Sub-Index Performance

Source: Bloomberg and Man GLG; as of 30 October 2020.

Haste Makes Waste

We believe that an analysis of ESG factors merits careful attention when it comes to emerging-market sovereign debt issuers and believe that it should be an integral part of the investment process. That said, we caution against hastily applied exclusion approaches from a regulatory level or investment level, as the issues are often multifaceted with many layers that should be viewed in context with the overall landscape of a country. Passive ESG benchmarks are similarly limited by narrowing the alpha opportunity set and focusing on a single factor (the ESG score) in isolation.

Instead, an active management approach is critical to navigating the emerging-market debt universe in order to maximise risk adjusted returns, in our view. Integrating ESG factors into the investment process can often shed light on larger credit concerns that may be lurking in the shadows, helping to maximise alpha and enhance returns. Investors cannot afford to ignore ESG issues, particularly in a world of increasing macro and idiosyncratic risks for many emerging-market debt issuers, where fragilities had been building up for years amidst excessive borrowing. That said, no single risk factor, including ESG, should be viewed in isolation, but in the context of overall fundamentals, valuations and positioning.

1. Office of Foreign Assets Control.