As Morningstar’s Global Emerging Markets Week comes to a close, we decided to take some time to consider what impact the rush of assets to emerging markets can have on the sustainable growth of these regions. This is precisely the question that prompted poverty-fighting, not-for-profit organisation Oxfam to team up with institutional investors in the UK and Europe to conduct a two-year study on the relationship between investment and development. The outcome of this collaboration is a report suggestively titled “Better Returns in a Better World”, which looks at how investors can influence poverty reduction and sustainable development, and attempts to assess the main barriers to greater consideration of development issues in investment. To better navigate the report and understand key takeaways for retail investors, we talked to Helena Viñes Fiestas, co-author of the report and policy adviser at Oxfam.
The Right Time for Development
The Better Returns in a Better World project comes at a time when the financial industry has identified both the need to diversify away from developed markets and replenish its stock of social trust, Vines Fiestas claims, seeing as the latter has been significantly damaged during the financial crisis. Reputational concerns, however, are not the only driver behind the City’s interest in a “better world,” Vines Fiestas explains, as contributing towards emerging markets’ sustainable growth was highlighted by the industry as a key variable for ensuring increasing returns.
To the extent that social engagement implies investment beyond the short-term, the view taken by Oxfam’s report is fully in line with the conclusions of Morningstar’s own fund analysis. As we pointed out in a recent article, the funds in the Morningstar Global Emerging Markets Equity category that have been awarded our Elite rating are precisely those which pay close attention to long-term corporate strategies and pick companies poised for sustained growth.
The Oxfam analysis, however, takes the objective of seeking returns beyond momentum-led market rallies a step further. In addition to sound corporate governance, fund managers need to select companies that demonstrate regard for poverty eradication and promote sustainable growth within the community where their business operates, the report concludes.
Ways of Impacting Sustainable Development
In terms of stock picking, the Better Returns in a Better World report identifies four key strategies through which institutional investors can introduce development issues to their portfolios. Firstly, a fund can exclude or include companies based on certain criteria (also known as negative and positive screening). Secondly, a manager can pick the best-in-class companies – those with the most sustainable practices within a particular industry or region. Thirdly, asset allocators can resort to integration – the inclusion of explicit consideration of environmental and social impacts in investment research. And fourthly, funds may chose to engage directly and influence corporate practices through informal channels or formal voting procedures.
As we have discussed in the past, negative and positive screening methods can be difficult to evaluate and track. Oxfam also points out that they may have limited real impact. That said, building a portfolio based on exclusionary criteria can play an import role, Vines Fiestas says: divestment can be quite effective as a threat. For example, in a market where ethical constraints are a popular consideration (Norway would be one such market), the possibility of a large pension fund considering divesting from a company would send a strong message to its management and the market as a whole. In addition, investment criteria, such as not investing in companies that are repeatedly reported to violate human rights, can be an important guarantee for investors with strong ethical preferences. “The downside of exclusion [as an investment strategy],” Vines Fiestas says, “is that it will always be niche.” In addition, apart from funds with specific exclusionary criteria--usually dubbed ethical funds, investment managers tend to see divestment as a last resort, the Oxfam report claims.
Oxfam also has reservations about the utility of the integration approach when applied on its own. “Integration without engagement is difficult when it comes to social issues because they are challenging to quantify” Vines Fiestas points out, adding that even when consideration for social issues is integrated into a portfolio management strategy, it is are normally applied after a call on equity selection has been made.
It is for these reasons that Oxfam promotes the strategy of engagement--an increasingly popular approach among institutional investors, Vines Fiestas points out. Some institutional investors in particular have began to see engagement as an opportunity to influence the emerging market companies they hold a stake in, particularly on issues such as transparency and corporate governance. “This is a trend, which is going to increase,” Vines Fiestas says. The Oxfam stance is that engagement is the most effective tool available to the investment community. If your objective is to create real change, you need to engage, and engagement is more effective when it comes hand in hand with ownership, Vines Fiestas explains.
How Do You Measure Impact?
The difficulty of quantifying the relationship between sustainable growth and investment is “the elephant in the room,” Vines Fiestas says. On the one hand, Oxfam has concluded that it is incredibly difficult to measure how much “irresponsible” corporate strategies can hurt companies’ profitability. The investment community has not produced anywhere near the necessary volume of research into the financial significance of environmental and social issues. “Many investment managers are simply not aware of the nature, scale and risks associated with development issues,” the Oxfam report states. But even if the lack of awareness and inherent difficulties in calculating the impact of social problems on corporate profitability were to be overcome, equity valuation models typically look at too short a time period for sustainability considerations to weigh much more than about 5% of the overall stock valuation, Vines Fiestas explains.
On the other hand, the inverse relationship--the potentially positive impact of sustainable investment on a community--is also difficult to quantify. As a result, fund strategies tend to focus on outlining the principles and objectives behind their sustainable investment strategies without disclosing in sufficient depth the outcome of these strategies, Vines Fiestas says. This status quo creates the need for better disclosure of information in order for investors to distinguish the funds that are really committed to sustainable development from those that are using the concept to support their marketing efforts.
Short-termism in Emerging Markets Investment
The difficulty in assessing impact and lack of transparency are among the key barriers to greater consideration of development issues in investment, Oxfam concludes. In addition, a prevalent short-term view in investment strategies and insufficient client demand present further barriers.
A critical point made by participants from the investment community in the Better Returns in a Better World project is that investment contracts or mandates are often for a three-year period, with one-year performance targets and quarterly reviews, which forces fund managers to focus on short-term financial performance. Consequently, managers seek to make quick profits and are less inclined to engage with companies and to seek long-term and sustainable profit opportunities. Here, it is important to recognise that long-term investment of the kind that yields sustainable growth can span across decades.
When allocating assets to frontier markets, investors need to understand that they may need to commit for much longer periods and lower their expectations for returns in the short term, Vines Fiestas says: “The investment community cannot continue to expect to increase growth rates and rates of return forever.” Oxfam also highlights the case for innovative approaches to investment in underdeveloped regions. In the various stages of their survey, Oxfam has identified an interest in such types of investment—such as public-private partnerships, which have been picking up in Africa, particularly from pension funds in the Netherlands.
Demanding Responsible Investment
Institutional investors are also already pushing the sustainable investment agenda in the UK. “An interesting conclusion of the study is that fund managers were much keener on adopting a sustainable agenda than the asset owners, and there was little demand coming from the clients’ side,” says Vines Fiestas. The average citizen lacks awareness, she claims, and the retail market is still in its infancy when it comes to championing sustainable development, with the exception of some philanthropy from high net worth individuals. Vines Fiestas says we should aim to create a sustainable investment trademark, in a similar way to how the Fairtrade coffee trademark has been established on the UK market.
To some extent, the lack of demand for ethical investment at the retail level is a result of a collective action paradox, whereby individual investors are not in a position to aggregate sufficient demand to sway a portfolio management strategy. Yet, Vines Fiestas says, if people start voicing ethical concerns more often, then you can surely count on financial markets to respond with their inherent speed and profit-orientation.
That being said, governments also need to face their responsibility towards supporting sustainable investment. If the available volume of government assets were to be invested responsibly, the debate could be totally changed, Vines Fiestas says. However, it’s important that both the private and the public sector to partake in the process. On the demand side, this means that individual investors needs to recognise that they are also tax payers, whose money is being invested by their governments, and as such they can leverage demand for responsible investment to both the public and private asset allocators.
Remember to Ask Your Fund Manager
What can individual investors take from the Oxfam report? “The first thing is to remember to ask your fund manager about the sustainable investment funds they provide,” says Vines Fiestas. Responsible investment should be the mainstream way of investing, and the individual investors’ community need not underestimate its ability to elevate demand to the level needed for this to take place. Just like it has with Fairtrade coffee.
