A Thematic Bottom-Up Approach to Emerging Markets

on

According to a 2019 UBS survey, “78% of clients are integrating environmental, social and governance (ESG) factors into their investment process.” Survey respondents noted that ESG risk were material and warranted being taken into account. Half of them also associated ESG with higher returns and an improvement in financial performance. As a result, asset owners also reported they believed ESG integration to be an integral part of their fiduciary duty.

As regulators and policy across the world promote long-term, responsible investing, particularly through the incorporation of environmental criteria in the investment process, the shift from motivating ESG integration to explaining its absence.  With business and policy considerations conspiring to support sustainable investments, international initiatives such as the UN Principles for Responsible Investing and the 17 Sustainable Development Goals (SDGs) endorsed by the UN General Assembly in 2015 offer a platform for cooperation and a roadmap for the future.

However, popularity can breed complacency and ESG-washing. Sorting through the wide range of sustainable investment opportunities can be a daunting task. One solution, investing in emerging markets (EMs), allows institutional investors to make a material contribution to the sustainable growth of developing economies in a relatively high return environment. However, the sustainability data problems that plague investors in developed markets are exacerbated in EMs. Identifying companies whose competitive edge best positions them to benefit from the sustainability paradigm shift requires a local presence to sort the wheat from the chaff.

Leveraging Thematic Trends

“The UBS Emerging Markets Equity Sustainable Leaders is an active investment strategy that seeks to identify industry leaders of structural trends in Emerging Markets and is aligned with Article 8 of the EU’s Sustainable Finance Disclosures Regulation (SFDR),” says Jie Song (Pictured), a Zurich-based Equity Specialist member of the strategy’s team. “The strategy invests in 30 to 60 high confidence stocks mainly across the five themes of climate change and the environment, healthcare, consumers and financial inclusion, digital transformation and the rise of AI, and the deglobalisation and reconfiguration of supply chains.” The thematic focus parallels some of the UN SDGs, including SDG3 (Good health and well-being), SDG12  (Responsible consumption and production) and SDG13 (Climate Action).

Jie Song, Equity Specialist at UBS Asset Management

According to Song, the strategy’s thematic focus allows it to exploit rising cross-sectoral trends. “Technological improvements combined with regulatory support allow the strategy to find opportunities in energy efficiency, smart mobility, energy storage systems and renewable energy to find companies likely to combine these technologies and the incoming regulatory.” This trend is fed by the rise of electric transportation, one of the main themes that UBS highlighted for 2021, and one which is sustained by demand from both developed as well as emerging markets.

“Meanwhile demographic trends suggest an increase in chronic health problems like cardiovascular disease, neurologic issues, oncology and obesity such that EMs are projected to increase healthcare spending by 24.4% vs. 9.8% in developed countries by 2040,” Song adds. “Leading pharma and biotech companies are well-positioned to mitigate the risk of falling drug prices and take advantage of new opportunities arising from changes mentioned above.”

“At the same time, the increase in household income will lead emerging market consumers to increasingly demand premium products with higher margins. Financial inclusion is part and parcel of this change as 31% of the global population, mostly concentrated in emerging and frontier markets, remain unbanked,” Song says.

Top-Down Insights

On a market level, UBS considers approximately 20 macroeconomic variables covering sovereign default and inflation risk, the financial system as well as political risk as an early warning system if these indicators exceed predefined limits in order to manage country-specific risks.

Sectorally, beyond the positive thematic focus, the strategy also applies exclusions. “The investment team takes the MSCI Emerging market index as its starting point and applies exclusions to companies exposed to sectors such as controversial weapons, tobacco, alcohol, adult entertainment and fossil fuels,” Song explains.

This is complemented with the team’s bottom-up investment approach that leverages UBS’s global footprint across emerging markets.

Boots-on-the-Ground

The strategy’s team is made up of 24 analysts, specialists and portfolio managers in Singapore, Zurich, Hong Kong and Shanghai, with a longstanding track record within Emerging Market Equities dating back to the Emerging Equity Asia strategy, which was launched at the end of October 1993. “The global scope of the team provides ‘boots-on-the-ground’ fundamental research and ESG engagement which can be leveraged to identify the companies likely to benefit from the thematic trends,” Song argues.

“This is particularly important in EMs, where companies typically suffer from low ESG scores according to traditional metrics, largely because of lower levels of public, English language disclosure. On-the-ground research and regular meetings with management allow for an informed view of the companies’ fundamentals and sustainability practices,” Song adds.

“The industry leaders we identify are clear long-term winners. Companies such as Taiwan Semiconductor Manufacturing (TSMC) or MercadoLibre, all outperform their benchmark index,” Song says.

The ESG Assessment

As part of the investment process, the strategy’s analysts must complete a rigorous quality assessment checklist of 30 questions for every company under consideration, covering how the three broad categories of “industry structure and competitive position”, “profitability trends and sustainability” and “ESG practices”.

The ESG assessment focuses on the integration of internal proprietary insights as well as external data from third-party providers such as MSCI, Sustainalytics or Institutional Shareholder Services (ISS). “These internal and external inputs are material to the strategy and are fed into UBS’s proprietary ESG Risk Dashboard for analysis. If, when the sustainable investment team conducts its assessment, it finds the company is too risky from an ESG-perspective, the stock becomes ineligible for investment,” Song explains.

According to Song, the strategy’s ability to deploy investment specialists locally across emerging markets is crucial to its ability to identify, review, decide and mitigate ESG risks and help EM companies unlock their ability to deliver competitive returns.

Identifying Opportunities

“In another instance, our team came across an insurance company which had some governance issues, including the same person as Chair and CEO for over 30 years and the absence of any lead independent director on its board. This presented a significant opportunity to unlock value through improved governance, transparency and ESG disclosures,” Song comments.

“Our engagement efforts focused on improvements to the board’s composition as well as disclosure on the compensation structure and risk management systems. Eventually, this led to 80% increase in committee-level independence across the Audit, Nomination and Remuneration committees, a meaningful reshuffling of non-executive directors, the Chair’s resignation from the role of CEO and the creation of three Co-CEOs,” Song says. “The company also started publishing a sustainability report and was selected to the Dow Jones Sustainability Emerging Markets Index.”

Engagement With Sustainability Practices

“On another occasion, our ESG Risk Dashboard flagged a food manufacturer’s lack of ESG disclosure despite considerable exposure to food quality and safety mismanagement risks. However, engagement confirmed good sustainability practices,” Song recalls.

“Continued market share growth, favourable industry consolidation and decreased competition made a compelling case in favour of the company. The investment team’s engagement focused on evaluating its ESG risk management practices and encouraging greater transparency. This led to an improvement of its profile on the Coller FAIRR Protein Producer Index, a benchmark to assess ESG risks for meat, dairy and fish producers. We continue to work with the company on enhanced disclosure, extension of the carbon and water reduction targets to the supply chain as well as Board independence and diversity,” Song adds.

According to Song, the investment process underlying the UBS Emerging Markets Equity Sustainable Leaders strategy provides a transparent and proactive path for asset owners to support the needs of developing countries. “Our approach allows the strategy to unlock alpha and reduce risk while leveraging our strength as a large, diversified asset manager to drive positive material change,” he concludes.

Image by Steven Yu from Pixabay

Sustainable ETFs in Focus

CME Sees Booming Demand for ESG Index Futures

Stockholm (NordSIP) - Following their launch on 24 May 2021, and as investors look to diversify portfolios with sustainable products, the new S&P Europe...

NordSIP Insights

Most read this week

IMP Graduates From Project to Platform

Stockholm (NordSIP) - To meet the targets of the Paris Agreement and the UN Sustainable Development Goals (SDGs), financial markets need to improve the...

Banks Miss ECB Climate Test