INGRAINED HABITS WILL HAVE TO SHIFT TO UNBLOCK INVESTMENTS INTO EMERGING MARKETS

In the institutional investing world few things matter as much as a benchmark. It is the line against which all fund managers are assessed. This can often seem frustrating to the end investor –who cares if my investment beat the benchmark but still lost 10%? For the fund manager, however, being better than the rest of the market is what matters. Indices are also the foundation of passive investment strategies – if that active investor is not beating the benchmark, why bother? Just invest in a portfolio that mechanically tracks the index.

As ESG has grown in prominence, professional investors have demanded new benchmarks that factor in ESG considerations. This has led to a cottage industry of index creation, but also considerable controversy.

As we make clear in much of this report, ESG is not a settled concept. While huge amounts of money are now being managed according to ESG frameworks, the specific companies that investors choose under those frameworks can vary greatly. So what should an ESG index contain?

A good example of the arguments that have arisen was the decision to exclude Tesla from the S&P 500 ESG Index last year. Tesla, the US-based manufacturer of electric vehicles, is a major disrupting force on traditional vehicle manufacturers. It has already shifted the entire industry to take electric vehicles much more seriously, promising to substantially reduce carbon emissions as a result. But the makers of the S&P Dow Jones Indices told Reuters it had kicked Tesla out because of issues including claims of racial discrimination and crashes linked to its autopilot vehicles. Critics were quick to point out that while Tesla had been booted, Exxon Mobil, one of the world’s biggest fossil fuel companies, was in the top 10 of the index. Tesla CEO Elon Musk responded on Twitter, “ESG is a scam”.

The problems arise because investors want very different things from an ESG index. Some see ESG as a way of reducing risks that arise from poor labour relations or relationships with customers. For them, kicking Tesla out of the index makes sense. But for others, ESG is about improving environmental and social outcomes in the world. For them, kicking Tesla out but keeping Exxon in makes no sense.

If there was a way of seeing the future, and determining what the longer-run impact of these companies is going to be on environmental and social outcomes, we could create the perfect index. But that is not how indices work. Fundamentally, they can consider only the information we have now, they are inherently backward looking. In this there is a sharp distinction between passive investors who follow the index and active investors who attempt to forecast and divine the future in making their investment choices.

These arguments have played out in South Africa. The JSE offers investors the JSE Responsible Investment Top 30 Index as its leading ESG index. A look at its members shows some surprises, including that half of the index is made up of mining companies. Tobacco and alcohol are in there too.

The index is maintained by FTSE Russell which has more than 300 indicators in its model that aims to measure the “quality of a company’s management of ESG issues”. Of course, the quality of management is not the same as assessing how material the ESG issues actually are. A company may well be a producer of coal, with no intention of diversifying into any sustainable alternatives, but still manage its ESG issues well in having good reporting standards, strong human rights and community engagement, good anti-corruption and tax compliance, and so on. If you are an investor who interprets “responsible investment” as avoiding any companies responsible for greenhouse gas emissions, then the index is not for you. But many other investors are aiming simply to boost returns by backing companies that are good at managing ESG risks, for whom the index is fit for purpose (see Introduction article).

As it is, retail investors would find it difficult to invest in the index as there are no exchange-traded funds based on it. The ETFs that are available along an ESG theme are all based on international indices. Satrix offers four and Sygnia offers two. How do the international indices do it? Given the controversy over Tesla, you won’t be surprised to learn there is quite some controversy over these too.

The MSCI index is based on MSCI’s proprietary ratings of companies, with only those earning a score above a certain threshold getting into the index. The index also excludes companies involved in alcohol, tobacco, gambling, fossil fuels extraction, thermal coal power and weapons manufacturing. Its design is therefore quite different to the JSE’s Responsible Investment index which includes British American Tobacco, Distell and Anheuser-Busch as well as at least one coal miner (Exxaro).

The MSCI World index similarly rejigs the weightings of companies but emerging markets make up a very small part of the basket. Research is increasingly indicating, though, that when ESG weightings are applied to such indices they end up downweighting emerging markets even more.

A recent report by ratings firm Fitch for the UK government’s Mobilist project found that ESG mainstreaming is exacerbating the under representation of emerging and developing economies in global capital markets. This is because there is an income bias in common ESG metrics in that wealthier countries tend to score higher and there are extensive ESG data gaps in emerging markets. This bias seems to be increasing – in 2018 the MSCI EM ESG index allocated 68% to countries that were rated by the OECD as emerging or developing countries but in 2022 this was down to 63%. If China and India are excluded, the decline is even sharper – from 33% in 2018 to 22% in 2022.

So while investors have been clamouring for ESG indices, the execution of the task has been fraught with difficulty. One set of difficulties is at the conceptual level – just what does ESG mean and how should it be reflected into the ratings methodologies used. Another is systemic – if ESG ends up biasing capital away from emerging and frontier markets, it won’t be supporting economies most in need of capital to meet the SDGs (which would very much include South Africa).

Part of the answer is surely that ESG investors should be less reliant on indices, but that calls for a shift in one of the most ingrained habits of professional investors in trading against a benchmark. As ESG captures more investment flows, habits will have to shift.

Members Of The Jse Responsible Investment Top 30 Index

1. Harmony Gold Mining Company Ltd

2. Distell Group Holdings Ltd

3. Nedbank Group Ltd

4. Clicks Group Ltd

5. AngloGold Ashanti Ltd

6. Exxaro Resources Ltd

7. Tiger Brands Ltd

8. British American Tobacco PLC

9. Impala Platinum Holdings Ltd

10. Gold Fields Ltd

11. Santam Ltd

12. Kumba Iron Ore Ltd

13. Absa Group Ltd

14. Anglo American PLC

15. Investec Ltd

16. FirstRand Ltd

17. Compagnie Financiere Richemont SA

18. Woolworths Holdings Ltd

19. Mondi PLC

20. Anheuser-Busch Inbev SA

21. Standard Bank Group Ltd

22. African Rainbow Minerals Ltd

23. Anglo American Platinum Ltd

24. Netcare Ltd

25. Sibanye-Stillwater Ltd

26. Aspen Pharmacare Holdings Ltd

27. MTN Group Ltd

28. BHP Group Ltd

29. Truworths International Ltd

30. Sappi Ltd