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How Chinese asset managers are leveraging ESG to gain alpha
Improved data quality and disclosure coupled with expanded research of ESG factors has enhanced the understanding of industries and companies
4 May 2020 | Bayani S Cruz

THE onset of the coronavirus epidemic is expected to heighten the urgency by which Chinese asset managers will integrate environmental, social, and governance (ESG) factors into their portfolios in order to generate alpha.

There principal reason is that there is a strong correlation typically between companies that have high ESG performance and the quality factor of these companies. And the market crash in the wake of Covid-19 has highlighted the arguable superiority of ESG focused stocks.

In the China market, MSCI China ESG Leaders Index posted a -6.79% return in the three-month period ending March 30 2020, when Covid-19 bulldozed the Chinese economy, but still outperformed the MSCI China Index which posted a -10.22% return in the same period.

Even before the crisis, Chinese ESG focused stocks demonstrated their ability to generate superior alpha when compared to their traditional peers.

Data from June 28 2013 to June 28 2019, show that over the period covered, the MSCI China ESG Leaders Index outperformed the MSCI China Index by 4.7 percentage points per annum, while the MSCI China ESG Universal Index outperformed the MSCI China Index by 0.9 percentage points per annum. The MSCI China ESG Leaders Index generated higher Alpha at higher active share levels but delivered a portfolio with a significantly higher Sharpe ratio and trailing earnings per share growth than the MSCI China ESG Universal Index. Still, the relative return of the MSCI China ESG Leaders Index in 2018’s bear market was negative, according to a study conducted by the UN Principles for Responsible Investment (PRI).

Historically, poor data quality and under-representation in major global benchmarks has been an issue for ESG investors interested in increasing their exposure to the onshore Chinese equity market. This is now changing, according to the PRI study.

Chinese asset managers have made progress in expanding their ESG research capabilities, while regulation has encouraged disclosure and onshore Chinese companies have increasingly been included in global benchmarks. In the first nine months of 2019, global investors increased their allocation to A-shares by approximately US$24 billion.

“And if we look at the current environment there’s this data analysis by MSCI, whether it’s on the fixed income side or the equity side, which has highlighted that high ESG-ranking companies on their analysis have outperformed,” according to the PRI.

To support the market analysis above, the PRI study cited the ESG integration strategies of five China-based asset managers including: China Asset Management, E-Fund Management, Harvest Fund Management, Hwabao Fund Management, and BNP Paribas Asset Management.

The PRI study concluded that while the quality of ESG data remains an issue, investment managers have found ways to utilize ESG-oriented insights and information to enhance their understanding of industries and companies.

China AMC, for example, used ESG considerations to validate fundamental insights and as potential flags for risk management, while E-Fund and Hwabao leveraged their perceptions of environmental risks and company management capabilities to enhance their understanding of industry competitive dynamics, which in turn helped portfolio managers make investment choices.

Harvest Fund applied a proprietary ESG framework and methodology to conduct quantitative ESG analysis across the A-share market, while BNP Paribas Asset Management identified three sources of alpha from sustainable investment practices including pricing of avoided risk, ESG momentum and the benefit of stewardship, and identifying opportunities through key ESG issues.

China AMC has developed an in-house ESG framework to analyze material and sector-specific ESG issues with a China focus which has made picking out the most significant ESG-related performance drivers to enable more effective stock screening. In the case of real estate, for example, third party data may not be sufficient to analyze specific issues relevant to the industry in China, hence, China AMC supplements third party research with localized analysis.

E-Fund Management, in 2018, conducted an analysis of two chemical companies in the China A-share market, which have similar business models and fundamentals. Analysis of their environmental practices concluded that Company Y had lower environmental risks than Company H. Company H’s target price-to-earnings ratio was therefore lowered from the industry average to reflect embedded risks. Because environmental risks were previously not fully considered, Company H was re-evaluated as overpriced and the outlook was switched to negative, meaning that its investment value was lost.

Harvest Fund has developed its own index in cooperation with China Securities Indexing (CSI), China’s leading domestic index company.

In November 2019, CSI published the CSI 300 Harvest ESG Leaders Index, a China A ESG best-in-class selection index customized by Harvest Fund Management. The index delivered 5.6% in annualized excess returns over the period of the PRI study while maintaining a tracking error below 3.0%.

Hwabao considers that ESG factors may be material to both reducing tail risks and enhancing returns, especially in the China A-shares equity market, where marginal improvements may help reveal investment opportunities. For example, Hwabao has done extensive analysis of ESG practices in Chinese printed circuit board (PCB) manufacturers, which may help identify companies with sustainable competitive advantages in the medium-to-long term.

BNP Paribas Asset Management (PNPP AM) has taken the view that meaningful engagement with issuers can benefit investments through the alpha opportunities associated with improving ESG performance while also having a positive impact on the company and broader stakeholders. For example, BNPP AM’s investment in Shenzhou International, a Hong Kong listed garments manufacturer, was supported by analysis of the company’s performance on key ESG issues that complement their competitive advantage.

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