ESG Investing: Reaching The Limit

The environmental, social and governance approach to investment has been gathering pace in Latin America. But running ESG funds is neither cheap nor easy, especially given fee pressures across the industry. Only a handful of investment managers with deep pockets are likely to prevail.

The investment funds that have integrated environmental, social and governance factors into their investment process have become the standouts in the dismal picture for capital flows into Latin American public equity. The dedicated ESG fund sector may be small, but it is dynamic and growing fast. The managers of these funds must rank stocks on ESG criteria, and they are using the information they gather as part of the overall stock selection process. This is giving ESG an outsized importance.

According to data from Morningstar Direct, assets in sustainable equity funds have increased massively, albeit from a low base of $253 million at the end of 2020 to $3.3 billion at the end of 2022. That is a stark contrast to conventional equity funds, which declined precipitously from $93 billion to $70.6 billion over the same period, the data shows. A rise in interest rates since 2021 explains a large part of the outflow from Latin American equities, a situation that seems set to stay for longer than anticipated. 

Tighter regulation in multiple markets, such as pension funds, is encouraging more take-up of ESG equity. 

Elena Tedesco, an investment consultant in sustainable and impact investing and former portfolio manager at Vontobel Asset Management and Federated Hermes, says ESG funds have been resilient because investors take a long-term view, often tied to a more sustainable vision of our future economic systems.

Investors in the Nordic region and Northern Europe continue to lead the way, she says. 

Fraser Harle, an investment manager at abrdn in London, agrees that the Nordics are in pole position, adding that abrdn, with its large presence in Asia, is starting to see more interest from clients there, from wealth platforms and family offices. 

In the United States, the picture is more polarized. There is pushback from clients who prefer to focus purely on returns.

It’s not only dedicated ESG funds that are moving the needle. Fund managers that have the resources are integrating ESG rankings into all their investments in varying proportions.

Mark Freudenthal, a former senior emerging markets analyst at DuPont Capital Management, notes that the team integrated ESG as a core component of its “quality” rating of a company, which accounts for one third of the score used to determine which stocks to buy. 

As companies provide more granular information, a greater range of fund flavors can be offered with specific climate mandates and gender diverse funds coming. 

Freudenthal thinks taking a holistic approach, where companies not only produce but have a blueprint for eliminating waste and recycling end products, will be next. 

RIPPLING OUT FROM GOVERNANCE

The path for most fund managers has been uncannily similar. Five to seven years ago, governance was front and center, particularly in a region known for crony capitalism and family-owned structures.

Progress has been patchy and with mixed results in, for example, the composition of boards of directors. 

Mexican boards are a bugbear. There is a chronic issue of over-boarding in Mexico where the same members sit on multiple boards. There is also a worrying lack of diversity, with older men dominating and very little turnover. Twenty-plus years of tenure is not unusual. That contravenes the best practice of changing members around every three years, says one senior fund manager.

In Brazil, by comparison, there have been improvements with stronger local institutions providing leadership, particularly the Association of Capital Markets Investors. 

Demands for more transparent reporting and the release of more complex data have come to the fore as environmental and social issues move into the limelight.

Fund managers often use ESG ranking tools from outside vendors, such as MSCI, Sustainalytics and S&P Global Trucost. But managers have been frustrated by their limitations. That is because vendors rely on disclosure from the companies themselves, as they do not have the resources to do deep due diligence themselves. And many companies provide extremely deficient and incomplete reporting. That makes the vendors’ ratings unduly harsh or incomplete.

“A lot of scoring is done on an automated basis. Vendors take reports, put them through a computer and if the right buzzwords pop up, they will gain a higher score,” says one fund manager. 

The publishing of annual sustainability reports or, failing that, the incorporation of key information, such as carbon dioxide emissions and water usage, into reports is still in its infancy. 

That has led large managers to scramble to assemble teams – with all the expense that this entails – to undertake ESG evaluations themselves. 

Abrdn, for example, has a team of roughly 30 looking at sustainability issues globally, which is run mostly out of an office in Edinburgh, says Harle. Abrdn can justify the costs. It has some $18 billion in emerging markets equities assets under management, and portfolio managers need to spend precious time during visits on gathering ESG data – instead of managing the investments.

This failure to disclose is particularly true of small and medium companies in Latin America, which often complain about form-filling and overlapping requests from different funds using their own methodology. 

The lack of reporting means that some companies are not selling their ESG credentials well. Paper and pulp companies may be unnecessarily vilified. One large investment firm in New York pounded the table with the vendors to get them to recognize the sustainability benefits with such companies, such as the replacement of single use plastic cutlery with wood products. Tedesco agrees that the paper and pulp sector is often poorly viewed despite the natural benefit of fast-growing eucalyptus trees in Latin America and the low carbon footprint of wood versus other construction materials

Some are simply recalcitrant. One company declined to offer ESG data as they felt it would confer an unfair advantage on the investor, says an investment manager. 

There are signs that transparency is improving. “We are seeing the hiring of sustainability and ESG officers at companies, which is improving the situation,” says Ed Kuczma, senior strategy principal at Danish software company SimCorp and a former Latin America portfolio manager. 

If one major headache is inconsistent and variable reporting, another is highly selective reports. Companies tend to over-egg their achievements and downplay areas of concern. They have been happier to set targets far off into the future and have to be cajoled to set intermediate targets, says Tedesco.

One large investor disinvested from Brazilian meatpackers when they would only set five-year targets for the traceability of cattle, where extensive use of third parties is made. 

“We told them to make it two or we would disinvest, and we did,” the fund manager says.

Still, Tedesco notes that a few years ago there were only one or two investable companies in the region, whereas there is a diverse choice these days. 

TOUGH SELLS

Kuczma says the make-up of Latin American economies with a preponderance of mining and farming makes the region a tough sell to ESG-sensitive investors.

Even global politics plays a part. Russia’s invasion of Ukraine has shone a spotlight on energy and food production. Investors are looking at obvious targets such as energy consumption and also the adoption of electric vehicles and renewable energy in everything from large mines moving soil through to distribution companies and the “last mile” of deliveries.

The issue of “materiality,” which looks at the equivalence between sectors, is key here. While carbon dioxide emissions is a key measurement for airlines, banks can highlight their low emissions, but this is less relevant given the nature of their business, says Freudenthal. To create an even playing field, banks are increasingly scrutinized for everything from reaching out to underserved communities – the region’s wealth disparities mean that it is vastly underbanked – through to doing due diligence on loans for their environmental and social impacts, providing services to municipalities in areas such as wastewater treatment and energy.

LAGGING IN REGULATION

There is widespread agreement that Latin America lags other regions in its regulation, by 10 years according to one senior fund manager’s estimate.

But there are signs of improvement.

At the highest level, politics matter. One fund manager points to the disparity of the excitement around nearshoring and the “Mexican moment” and the more humdrum reality. Mexican President Andrés Manuel López Obrador has lionized Pemex, the state oil company, in its role in the country’s energy mix, and this has slowed the transition to more efficient energy use. Perversely, national policies strongly discourage the take-up of rooftop solar panels, for example. Tedesco sees next year’s elections in Mexico as a possible reset point for policies and an opening point for investments. 

At the financial market level, McKinsey Global Institute analysis from this year highlights that Brazil, Chile, Colombia and Mexico have recently taken concrete steps to strengthen regulatory requirements around corporate disclosure, sustainable banking and climate-risk management.

FUTURE HURDLES

What could stymie the growth of ESG funds? First and foremost is fee pressure across the industry. Across the Americas, the average fee for mandates for ESG exchange-traded funds (ETF) is 37 basis points. That means more complex products requiring deeper research will remain the purview of specialist funds willing to buck up. 

Then there is a strong concentration of ESG ETF assets among larger managers with BlackRock representing 54% of all such assets in the Americas. 
Only companies that have deep pockets can dedicate the resources to buying data, visiting companies, monitoring targets and scoring them, and working out how to integrate those results into an investment process that can compete. Big managers win out. If investor demand continues to increase, the choice of managers and specialized mandates will surely remain limited by the expense of running such funds. LF