What matters for financial returns?
China, as we set out in our previous blog, is playing an increasing role in global financial markets and, by extension, investor portfolios. At the same time it presents investors with a number of unique Environmental, Social, and Corporate Governance (ESG), as well as political, risks.
How do investors set the ESG boundaries to navigate around them? We believe the key should be focusing on what matters for the financial risk and respective returns.
China is one of the largest carbon emitters in the world but the government has committed to a net carbon target in 2060. While there is no conclusive evidence on how environment issues will affect financial returns over the long run, it is simply a risk that investors cannot ignore. At the end of April 2020, the MSCI China Equity Index’s carbon intensity (217) is still higher than the MSCI All Country World Index (179) but it is lower than the emerging markets (298).
Awareness of human right and worker right issues in the international community is increasing. Some of the social issues as a result of government intervention decisions can spill over to companies; e.g. a number of companies (including global brands) were reported to have been using Uyghurs’ labour from the re-education camps. We expect to see impacts at a company level as a result of boycotting or sanction responses from international governments and activist groups. So far the impact of sanctions at an index level is not yet material. However, there is a risk that more companies will be sanctioned or affected by supply chain related boycotts in the future.
The political risk is essentially a form of governance risk at the government level which takes the form of interference. As a result, industries and financial markets lack true freedom and are highly affected by government decisions and policies.
Chinese companies have a lot to catch up on governance quality. And State Owned Enterprises (SEOs) present the most prominent governance issues. They are often in industries with a role to carry out the country’s strategic planning, which leads to poorly aligned interest with the investors.
When comparing all the E, S, and G factors, governance has the most significant and direct impact on investment returns because it is an issue directly or indirectly associated with every Chinese firm. Company returns may be hurt by poor management and questionable accounting, and sector dynamics could be affected by government decisions rather than “the invisible hand” of the market.
When investing in China, always go back to the 'ABCs'
The consideration shouldn’t just stop here. It is also important to go back to each investor’s Aims, Beliefs and Constraints, including their ESG policies.
- Is an allocation to China an appropriate fit given the investor’s objectives? Is there a need for an additional growth allocation with low correlation to existing assets?
- Does the investor have a long enough time horizon to see China’s growth story play out?
- How much governance is the investor willing to carry out to understand the risks specific to China? How much time is the investor willing to budget to monitor the risks?
- Does the investor believe that, in the long term, poor ESG credentials will lead to financial underperformance?
- Is there a justification to avoid investing in China for ethical reasons? We touch on this further below.
Addressing ESG issues as an investor
Low governance investors could consider climate aware and ESG versions of the indices but we note that the efficacy is limited here. We believe the best way to address ESG risks in China is through active management where the ESG risks are considered in stock analysis and undesirable companies can be avoided. Investors can also help improve companies’ ESG standards and practices through active engagement.
Where there is an ethical reason to avoid China, careful considerations are needed on exclusion. Exclusion is likely to significantly reduce the investment opportunity set; e.g. China represents 40% of the emerging markets. Be mindful of crude exclusion rules because issues such as human right violation are not unique to China so it may lead to unintended exclusion.
Finally, investors seeking to avoid China exposure should be aware that for some companies, production and sales are increasingly linked to China if they do not already form a meaningful proportion. If investors are going down the exclusion route then where should that stop?
Positive changes in China for investors
Thanks to growing investor demand in ESG disclosure and integration in Chinese investments, China is making positive changes in environmental initiatives, policy and regulation, as well as ESG reporting. Foreign investors are playing a key role in guiding, engaging and rewarding positive progress.
If you would like to talk about this topic, please get in touch with your usual Barnett Waddingham contact to find out how we can support you. Alternatively, please contact me below.
For professional use only. The information contained in this article is provided for informational purposes only, and should not be construed as advice.
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