ChapmanCraig

INTRODUCTION

We recently posted notes reflecting on the tremendous increase in interest in sustainable or responsible investing.

Many clients would like responsible investing to play a fundamental role in the decisions shaping their investment portfolios. The goal is to feel that you are doing good while seeking financial returns, by supporting positive social and environmental changes.

Investment managers increasingly understand the need to accommodate sustainable investing. This is, in part, because surveys suggest that millennials and women are particularly focused on responsible investing, two demographics that will become increasingly active in selecting investment managers.

GENERAL RATIONALE

Applying ESG factors to investment decisions likely leads to a more complete analysis because it involves analysis that might have been overlooked by traditional approaches.

While there are significant definitional and measurement issues to applying or measuring sustainable or ESG investing, investors appreciate that certain key sustainability issues will certainly impact a company’s ability to generate long-term financial returns.   These include a failure to anticipate changes in environmental standards, poor governance and financial transparency and labour practice that impede retention or promotion of qualified employees.

Not all ESG risks are company-specific. Investment surveys have also identified countries with poor ESG performance that contribute to poor financial outcomes for investors and domestic companies.  This could be the result of inequitable regulatory regimes, political interference or corruption, inadequate preparation for extreme weather or poor-quality financial infrastructures.

For these and other reasons, many commentators suggest that emerging economies may be more vulnerable to ESG-related issues than are developed economies. In addition, emerging market companies themselves often rate poorly on ESG measures.  This may be, in part, a measurement issue resulting from managements often failing to appreciate the importance of providing useful information.

As a result, proper implementation of ESG factors into the investing process may well enhance performance or reduce volatility to a greater extent than would be the case with respect to developed markets.  For instance, Blackrock has found that application of ESG factors in EM resulted in a more significant improvement than they found in DM.

And yet, ESG issues appears to be less embraced by Asia-based investors than has been the case in Europe. A UBS survey suggests that the majority of HNW investors in China are concerned that “sustainable investing” will result in lower investment returns.

Letko, Brosseau & Associates, a Montreal-based investment manager that manages our client portfolios, takes the same bottom-up approach to stock selection to its emerging markets strategies. LBA takes a long-term investment approach and believes that integrating ESG considerations into its investment decision-making as part of their mandate to deliver long-term returns. Oversight of ESG integration resides within their management committee.  Its investment committee is responsible for ensuring that all material ESG considerations are incorporated into the analysis and selection of each emerging market investment.

Those fund managers applying ESG factors to EM, including LBA, have identified a number of useful signals:

• strong (or lack of), independent board oversight,
• the competence, experience and diversity of senior management,
• exposure to inappropriate political interference or involvement,
• transparency in financial reporting and with respect to related party transactions and interests,
• a commitment to global environmental and labour standards (or at least local standards), and
• preparedness for environmental disasters, damages to important infrastructure or social unrest.

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INTRODUCTION

Many families want responsible investing to play an increased role in the design of their investment portfolios. The goal is a greater alignment between their investments and their personal values, promoting outcomes that are financially rewarding while supporting positive social and environmental change.

Investment managers increasingly understand the need to accommodate sustainable investing, once considered a fetish.

However, obstacles to adoption include confusion around terminology, rationale and implementation.

Investors in the U.S. and Asia have been generally slower to embrace ESG factors or other approaches to responsible investing than have Europeans, because they appear less convinced that it will be impactful and would like clearer evidence of a positive impact on financial performance. But evidence suggests that when a client does decide that ESG investing is important, they do not just nibble, they seek significant ESG allocations.

While not all managers expressly state that they apply ESG factors, good investment analysis necessarily identifies sound corporate behavior and objectives that serve to protect the company and its stakeholders. It would seem unwise to ignore key sustainability issues when assessing a company’s ability to generate long-term financial returns.

 Implementing Within the Investment Processes

JPMorgan estimates $23 trillion of assets are now managed applying ESG factors as a part of the investment criteria, with over $100 billion invested in ESG Funds. According to Barrons, US assets managed under ESG mandates grew 23% (CAGR) between 2014 and 2016 (compared to an average of 5% for the industry as a whole). Approximately half of US financial advisors now have portfolios dedicated to ESG investing.

Applying ESG factors to portfolios, funds and sector indices take a range of approaches including: (i) exclusionary approaches, applying broad principles, or screens or sector bans; (ii) “positive” approaches that include companies with certain performance or improvement scores; and (iii) thematic, or impact, investment approaches.

Measurement Issues

However, ESG classifications can be problematic. It is difficult to manage and report on that which is hard to measure.

ESG data are a means to assist an investor to evaluate a company’s strategy, institutional purpose and management execution and understanding how the company is adapting to transformational change (e.g., changing consumer preferences, evolving policies addressing climate change).

Morningstar (via Sustainalytics) and MSCI have created sustainability ratings to assist in evaluating or scoring mutual funds. Moody’s and S&P now incorporate ESG data into their credit ratings.  But some managers, such as GMO warn against a broad application of third-party scoring systems.  It is also important to identify those factors that are truly material for any particular industry and company.

Implementation Issues

 A consensus is lacking as to what ESG or sustainable investing involves, whether the integration of such in the investment decision is based on seeking improved financial performance or reduced risks (or both), or is simply an attempt to align portfolio construction with personal values.

Like any new trend, responsible investing has its critics.  Some question whether it even is appropriate.  However, more often critics point to difficult implementation and measurement issues.

1.  Definitional Issues

Even though integrating ESG factors within investment decisions has clearly accelerated since 2012, definitional issues appear to be holding back adoption.

The UN’s Sustainable Development Goals created a framework in 2015, but the 17 goals are rather general and difficult to translate into portfolio design.

It is hard to monitor compliance with the Principles of Responsible Investing, even ignoring that many signatories have done little to implement the spirit of the goals.

2.   Not effective in changing corporate behavior

Many critics argue that it would be more effective to engage with managements on broad issues such as climate change, diversity or governance, rather than simply divest.

Some have argued that if too many fund managers exclude certain sectors, then the cost of capital will increase for those sectors and while there might be supply constraints later, it could positively impact the sector’s future returns, perversely.

3.  Limiting choice necessarily results in worst outcomes

The argument is, the larger the asset class you want to exclude, the greater potential underperformance (vis-à-vis a benchmark).

There remains debate on whether ESG has demonstrated itself as a useful style factor.

4,   Is a fad – asset managers owe a duty to focus on the traditional, widely-accepted analytical approaches

Some have questioned whether asset managers owe a fiduciary duty to their clients to take ESG issues into account. In the US, there has been arguments that the manager’s fiduciary duty is focused on financial performance, and that applying ESG factors constitutes activism which may not be part of the manager’s mandate.

For example, when aligning “core” values, are those the values of the manager or of the clients or as prescribed by activist or independent groups. Clients necessarily have a broad range of values.  Communities sensitive to “political correctness” may see this as a liberal intrusion into an otherwise allegedly scientific process.

5.  Primarily a marketing ploy, since quality investment manager s already apply these principles

Others argue that applying ESG factors is redundant because the best companies and best asset managers are already incorporating these factors within strategic and investment decisions. The sustainability of their business model has always been relevant. It is suggested that developing these new frameworks and reporting systems is more likely to confuse and increase costs without a commensurate benefit.

In addition, commentators point out that fund managers often trumpet ESG credentials and commitments and yet have changed their investment approach very little. Companies lay claim to integrate ESG factors into their strategic planning, but it is very resource intensive and time consuming to collect, catalogue and present performance or compliance confirmation.

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We think it unlikely that there will ever be a consensus on specific frameworks for responsible investing, its role in asset manager deliberations and how best to implement, but so long as research continues to support a connection between sustainable business models and financial performance, and certain demographics increasingly champion the goals, asset managers will be offering a range of approaches to integrate ESG factors and responsible investing. Borrowing from Voltaire – waiting for the perfect approach should not prevent asset managers from improving on current approaches.

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INTRODUCTION

Many families want responsible investing to play an increased role in the design of their investment portfolios. The goal is a greater alignment between their investments and their personal values, promoting outcomes that are financially rewarding while supporting positive social and environmental change.

Investment managers increasingly appreciate the need to accommodate sustainable investing.  Trends supporting interest in ESG include increasing awareness amongst asset managers that (i) sustainability issues do impact financial performance, and (ii) millennials and women, two demographics that will be managing an increased share of AUM going forward, have demonstrated an affinity to responsible investing (potentially impacting manager selection).

However, obstacles to adoption include confusion around terminology, rationale and implementation.

For example, are ESG (environmental, social and corporate governance), sustainable, socially responsible and impact investing different names for essentially similar evaluation frameworks, or would they require substantially different implementations in the eyes of the cognoscenti? 

 We believe that at a broad level, each of these concepts encourage the integration of the clients’ personal values or society’s perceived concerns or an entity’s mission into consideration, alongside traditional criteria, when making investment decisions.

 GENERAL RATIONALE

Applying ESG factors to investment decisions likely leads to a more complete analysis of the investment opportunity because it involves analysis that might have been overlooked by traditional approaches.

DWS and the Univ of Hamburg reviewed (in 2015) the conclusions of over 2000 studies and found that the majority of such studies found a positive relationship between ESG factors and corporate financial performance; while relatively few found a negative relationship.

A long-term study by JP Morgan found that stocks with the poorest ESG scores exhibited greater volatility during choppy markets … supporting the view that sustainable investing may help make investment portfolios more durable.  A recent Bank of America study found companies with better ESG performance exhibited lower earnings volatility and higher ROE over the period reviewed.

While not all managers expressly state that they apply ESG factors, good investment analysis necessarily identifies sound corporate behavior and business strategies that serve to protect the company and its stakeholders. It would seem unwise to ignore key sustainability issues when assessing a company’s ability to generate long-term financial returns.

IMPLEMENTATION

Developing a Framework

There are over 2,000 signatories to the U.N.’s responsible investments initiative, established in 2006 and called the Principles of Responsible Investment (PRI).  Signatories commit to six principles designed to embed ESG considerations into investment decision-making processes and to hold the companies in which they invest to account for ESG failures.

In 2015, the U.N. set out 17 Sustainable Development Goals (SDG) relating to societal challenges including poverty, inequality, climate change, the environment and justice.  Its intention was to redirect investments to address specific problems that may not attract capital purely on expected financial performance metrics, with the goal to achieve a cleaner, healthier and more equitable world.

However, given the broad nature of the goals as well as the implementation language having been prepared for governments rather than investors, it has not been easy for investors to translate these goals to specific practices.

Implementing Within the Investment Processes

JPMorgan estimates $23 trillion of assets are now managed with at least an indication that ESG factors play a part as investment criteria, with over $100 billion invested in ESG Funds.

Managers applying ESG factors to portfolios, funds and sector indices apply a range of approaches including: (i) an exclusionary approach using screens or sector bans; (ii) a “positive” bias designed to include companies with certain performance or improvement scores; and (iii) thematic, or impact, investing.

 1.  Exclusions based on broad failure.

As a first step, responsible investing will look to avoid companies that fail to meet the most basic standards on issues such as corruption, environmental degradation and human rights.

2.   Systematic exclusions.

The early and still a predominate ESG approach is to exclude sectors seen as not meeting society’s priorities. Initially, these tended to be the so-called “sin” stocks (gambling, alcohol and tobacco).

An exclusionary approach has to deal with how broadly a net is thrown. Do you exclude companies that sell alcohol or tobacco (food retailers, pharmacy chains) or just manufacturers?  Do you exclude weapons manufacturers or also those providing components or that have much larger businesses in other sectors (e.g., Boeing or Airbus)? Do you exclude all fossil fuel producers, or only the products with the highest carbon intensity?

This exclusionary approach is sometimes criticized as: (i) being too limiting, potentially hurting returns, (ii) not doing enough to encourage behavioural changes, (iii) not having a strong economic rationale, and (iv) presents a risk of capture by social activist movements.

3.  Screening-based inclusions.

Arguably, a more effective ESG approach goes beyond exclusions as managers become more focused on what to include, as much as what to exclude. Under a best-in-class or positive approach, companies are included or emphasized that have the strongest ESG credentials.

This approach is useful for managers that want to label a fund as ESG based on quantifiable measures (although there are questions about the effectiveness of third-party scoring models).

4,   Integrating ESG factors.

The recent trend is a more comprehensive approach whereby ESG factors are integrated with traditional analysis to improve the investment decision-making process and highlights risk.

For example, a manager with whom we work closely, states that:

“… our approach to investing responsibly and integrating ESG considerations is guided by our mandate to deliver returns that will enable our clients to achieve their long-term investment objectives and our core values.   We believe that companies with sound business practices, including strong corporate governance and responsible management of material environmental and social issues, have better success and deliver stronger financial performance over time.  Conversely, companies that have poor environmental, social or corporate governance practices present risks and controversies that may hinder their financial performance.” 

Under this approach, industry analysts investigate ESG risks as part of their in-house research process and may compliment that work with third-party research. Conclusions are integrated into investment decisions.

This approach can also run alongside an exclusionary framework. For example, the manager cited above excludes tobacco, gaming and thermal coal miners from all portfolios, while its ESG Fund adheres to a much more restrictive investment policy which precludes investments in companies for which ESG information is insufficient or which do not pass certain ESG filters.

5.  Thematic Investing.

Thematic or impact investing generally funds strategies addressing specific environmental or social challenges.  This is often done through investment vehicles that are private and project oriented.

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The vibrancy and high growth rates of emerging market economies are often alluring for investors looking to add incremental growth and exotica to their portfolios. The high under-lying growth rates, huge population base and a perception that less transparency and analyst attention suggest that these markets are less efficient was the start-point for many fund pitches.

There have been two broad approaches for adding emerging market exposure to segregated portfolios:

1. indirect exposure, by investing in well-run western companies with significant emerging market businesses; or
2. direct exposure, through ownership of companies based and operating within one or more emerging economies.

Our portfolios have historically had a mix of the two, with the bias being toward the first approach. Our portfolio manager is dedicated to a detailed, bottom-up analysis of each company that it evaluates.  This approach is often more challenging when it comes to emerging market issuers, in part because of less access to management, frequently the lower quality of financial information, the reticence of EM management teams (that were not used to that sort of due diligence process), and frankly, less confidence in the quality of corporate governance.

However, the balance has been shifting towards direct exposure over the past decade, as these issues are addressed by more and more management teams in the emerging markets. Client portfolios now have direct exposure to emerging markets at, or slightly above, the MSCI ACWI allocation.

However, and as you are no doubt aware, these elevated growth rates enjoyed by emerging economies have not always translated into elevated total returns for minority investors in emerging markets companies. EMs have had periods of exceptional performance and then periods of under-performance, such as we witnessed in 2018.  In addition, volatility has historically been considerably higher than in developed markets, producing unenviable Sharpe ratios (although Bloomberg Markets pointed out last week that short-term volatility in developed markets was currently above that in emerging markets, a very rare event.)

So what changes, other than greater comfort with due diligence processes, give us more comfort with direct EM exposure than was the case historically?

Emerging economies now represent almost two-thirds of total global GDP, while their stock markets represent approximately one-third of global market capitalisation.   Key global indices have an even lower allocation to EM, at around 10%.  As more China-listed companies are included in indices over the next few years, that figure will rise, but it will still remarkably understate the importance of those economies to global growth.

While emerging economies typically exhibited higher growth rates, their economies were not as large and influential to total global growth as were the developed economies. However, whether it’s China, India, southeast Asia or EM as a whole, their absolute scale has become very important, not just their relative growth.

A recent paper from the Brookings Institute estimated that over 90% of the increased spending power of the global middle class will come from China, India and other Asian emerging countries by 2022.  In other words, the impact that these economies have on global growth is now impossible to ignore.

Second, the composition of what drives emerging economies is evolving. In boom periods of the past, growth was led by low-cost, export-driven manufacturing, domestic property development typically fueled by cross-border capital flows and resource extraction industries.  This led to considerable volatility in EM returns during a business cycle.

However, the less volatile and often domestically-oriented sectors such as healthcare, consumer staples and consumer discretionary sectors are becoming more relevant. In most Asian EMs, the technology sector, albeit still export-oriented, is now much more important – although whether the chip makers and components suppliers have managed to reduce cyclicality is currently on trial. The MSCI EM index now comprises over 40% of technology and consumer sectors.

Third, research focused on the increasing integration of ESG issues (environmental, social and corporate governance) into company analysis and investment decisions has highlighted that this approach is particularly helpful in evaluating risks in the emerging markets. Assuming this is true, and we believe that it is, then the detailed, bottom-up style of investment research (as opposed to the use of passive products) should enhance returns over time, relative to the same impact with respect to developed markets.

Finally, from a relative value perspective, EM currently looks very attractive. While the relative value between EM and DM is somewhat cyclical, the end-of-2018 MSCI EM relative to the MSCI World (normalized to early 2008) is extreme, historically.

As 2019 market outlooks were distributed in the first two weeks of January, it is clear that emerging markets are again very much in the conversation. The large sell-side houses seem about equally divided on the attractiveness of the asset class, informed in large part by their outlook for global growth, the likely strength / weakness of the USD and the likelihood of two or more Fed rate increases during the year.

We do not market or promote any fund products, but if you are interested in more information on how our client exposure to emerging markets is expressed within their segregated accounts, please contact us.

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Since 2016, Keelan Chapman has been actively supporting our clients in his role as Real Estate Consultant at ChapmanCraig Ltd.   Concurrently, Keelan manages the Canadian Real Estate Investment Center (H.K.)  which assists Asia-based investors in making property acquisitions in Canada.  He was recently highlighted in an article penned by Nathan Vanderklippe in the Globe and Mail, one of Canada’s leading business newspaper.  The article, titled “The Re-returnees”, was published on January 13, 2019, and below in italic is an excerpt.

       When Keelan Chapman moved back to Hong Kong three years ago, he didn’t expect to find himself with a front-row seat to a Canadian exodus.

       Mr. Chapman runs the Canadian Real Estate Investment Centre (Hong Kong), a company he created three years ago to help people in Asian buy property in Canada. He figured his clients, who meet him in Hong Kong’s skyscraper forests of buzzy coffee shops and swish boardrooms, would be investors moving cash into Vancouver’s exuberant housing market. 

       What he has found instead is people looking to buy homes for themselves.

      “My main clients in Hong Kong tend to be Canadians looking to return to Canada,” he says.

An active member of the Canadian Chamber of Commerce in Hong Kong, a founding member of the Pearl River Delta Canada Chamber and an engaged member of the Alumni Association of McGill University, Keelan often speaks at conferences on the Canadian Real Estate market, giving specific updates on the Vancouver, Toronto and Montreal real estate markets as well as on recent implementation of various taxes affecting real estate investors.

From his experience, buyers are interested in Canadian properties for three reasons: investment, for a retirement home or for young families returning so their children receive education within the Canadian education system, whether it be secondary, post-secondary or university.

Vancouver and Toronto continue to attract most interest due to strong family ties developed over the years.   However, since the steep price increases and various policies aimed at foreign buyers in these cities,  Keelan has noticed that he is getting more inquires for cities like Montreal (Canada’s second largest city) where prices are affordable, yields are strong and there is a growing dynamic wave coming from high-tech companies that are looking to take advantage of the city’s collection of world class universities.

Keelan is a licensed real estate broker in the province of British Columbia and regularly travels back to Canada to assist his clients in real-estate matters.

There has been a flurry of changes to UK tax laws that, along with additional proposed changes, significantly impact the ownership of UK residential property through off-shore structures.

The tax exposure of UK non-residents owning UK real estate depends, in part, upon how it is held. Its use remains relevant but will become less so as some exemptions for commercial or investment properties are phased out.  As a result, offshore ownership structures may need to be revisited, if you have not done so already.

Non-Doms and Inheritance Tax (IHT)

UK property owners often used offshore companies to hold property to avoid IHT (amongst other purposes). This may have been advantageous even if it meant losing the principal residence exemption under CGT on sale.  Shares of offshore companies are not caught within the UK’s IHT regime unless the owner is (or is deemed) domiciled in the UK.  [UK domiciles are subject to IHT on their worldwide assets.]

In addition, transfers of shares avoided the stamp duties (SDLT) normally charged on property transfers.^[i]

A 3% SDLT surcharge now applies where the buyer owns another residence, including residences outside of the UK. But the surcharge will also apply, even in the case of a first residence, where it is purchased through a company or discretionary trust.

Similarly, individuals that were resident in the UK, but treated as “non-domiciled”, could avoid IHT for certain properties if the settlement of a trust had been properly completed before the individual became UK resident.

Starting in 2017, excluded property trusts will no longer effectively shield a residential holder of UK real estate from IHT because shares of offshore companies that own UK real estate will no longer be considered excluded property.

Additional IHT taxes might also apply on a periodic basis prior to death in certain circumstances. Mortgages on UK property could now be exposed to IHT or be unavailable to reduce IHT liabilities.

In addition, tax changes effective in 2017 shorten the time during which long-term residents will not be deemed to be domiciled for IHT purposes and will treat individuals born in the UK as domiciled as soon as they become resident in the UK, even if they had acquired a new domicile by choice in the interim.

Recent Changes to Capital Gains Tax

UK taxes on capital gains from disposition of property previously applied to i) residents and ii) gains connected to UK real estate. This led some to hold UK real estate within offshore structures.

However, starting April 2015, non-residents (including non-resident companies) disposing of UK residential properties became subject to the non-resident CGT regime (costs rebased to April 2015).

The UK intends to apply the CGT regime to sales, occurring after April 2019, of any UK real estate held by non-resident individuals and companies, including commercial property (with perhaps some exemptions for institutional investors). By April 2020, gains on disposition of UK real estate owned by offshore companies may be taxed under the corporate tax regime, rather than under CGT.

In addition, HMRC had seen some push back from the EU on certain taxes imposed when property ownership was exported from the UK.  Following Brexit, some of those relaxations may be repealed.

Annual Tax on Enveloped Dwellings

ATED was introduced in late 2012 to tax offshore entities that hold UK residential property. The legislation addressed a perceived lack of fairness as to how non-Doms and offshore owners of expensive London properties were being treated, vis-à-vis UK residents.^[ii]  Investment (or buy to let) properties were initially exempted from the tax.

Offshore companies holding UK residences worth more than £500,000 now pay an annual ATED charge (a sliding scale depending upon value) and will be responsible for a 28% capital gains tax on dispositions (costs were rebased as of April 5, 2013).

Evolving Registration Requirements

Although many of the tax advantages of owning UK property through offshore structures have been eliminated, one of the remaining attractions was enhanced confidentiality.

However, in January the UK clarified rules requiring offshore entities that own UK real estate to complete a public registration. The registration, expected to be in force by early 2021, will likely require the entity to identify its ultimate beneficial owner(s). While the purpose is to address transparency and money-laundering issues, it is consistent with a policy objective to discourage using offshore companies to own UK residential properties.

Additionally, under new rules, non-resident trusts that hold UK assets (or receive UK-sourced income) will need to register. The deadline for registration depends upon the UK taxes that are payable.

As we discussed last year, investors should be aware that the Common Reporting Standard arrangements, by now in place in most countries, will provide tax authorities with considerably more information than they have had previously with respect to financial accounts held offshore.  The first package of account information will be sent by HK authorities to the UK by October this year, for example.

Investors that have implemented wealth planning that uses an offshore structure to hold, or make loans related to, UK real estate that were put into place some time ago should carefully review their plans with their professional advisors. Some flexibility present prior to April 2017 will have been lost by now; but curing structures that create unnecessary exposure may still be advantageous.

[i] SDLT on residences starts at 2% for a cost of £150,000 and increases with cost up to a maximum of 12%.  There is also a 3% surcharge where the buyer already owns other properties.  Where an entity is the buyer, a 15% supercharge may be chargeable.

[ii] UK had started to expand its reach to offshore companies being used to mitigate CGT and IHT in 2008 through a new section 13 charge, attributing what would normally have been offshore capital gains to shareholders of closely held companies on a proportionate basis.  The EU somewhat dialed back the application of this charge on freedom of mobility grounds, in 2013, prompting further legislation from the UK.

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