Investing strategies need to consider emerging markets’ potential for improvement, not just their risk scores, Fixed Income specialist John Berry writes, as our experience in Uzbekistan illustrates.
Looking for simple answers to complicated questions is part of human nature. In Douglas Adams’ The Hitchhiker’s Guide to the Galaxy, a supercomputer is designed to provide relief to our existential angst and finally answer the “ultimate question of life, the universe and everything”. After 7.5 million years the computer reluctantly delivers its answer: 42. Meaningless questions get nonsensical answers.
ESG investing sometimes feels almost as broad as the ‘ultimate question’, and it is tempting to import vast amounts of data, throw it into a supercomputer to generate an arbitrary number, and then confidently assert that you have ‘answered’ the ESG ‘question’. In practice, of course, the questions you ask depend on what you’re trying to achieve – your purpose.
In investment the traditional goal is to deliver the best risk-adjusted returns for clients. The initial ESG approach was therefore to treat ESG factors only as risks to those returns. This was convenient as it involved only minor tweaks to existing investment frameworks. However, clients have always cared how returns were made, and the surge in interest in ESG reflects a growing dissatisfaction with the investment management industry’s willingness to pursue a quick, but ultimately unsustainable, buck.
IMAGINING THE FUTURE
In our Emerging Market Debt strategies our purpose is clear: to generate resilient income for our clients by investing their capital in companies and countries which are contributing to a sustainable future. It is our core belief that countries which invest in their natural, human and institutional capital, and companies which make a positive social contribution, are more likely to prosper in the long run – and therefore more likely to offer attractive long-term return for our clients.
It is precisely in emerging markets where we as investors need to challenge ourselves to avoid looking for simple answers. To have a chance of being successful, a thoughtful ESG approach to investing needs three key elements:
- avoid the seductive simplicity of relying on available data
- be forward-looking and focus on each country’s trajectory
- be considered in the context of each country’s level of development
We believe that our approach allows us to meet our purpose.
Focusing on hard data might seem like a transparent, objective way to assess ESG performance. In reality, it is anything but that. ESG data for emerging markets is incomplete and backward-looking. A data-led approach can therefore fail in its aspirations and risk doing harm by favouring rich countries, well-resourced sectors, and placing too much emphasis on historic performance.
We do not ignore the data, but it is only a starting point when imagining a country’s future trajectory. To deliver great investment performance we need to question the lazy extrapolation of recent trends and instead anticipate deeper shifts in society. We will sometimes get it wrong, and for some people our interpretation of a sustainable future will differ from their own, but our approach is characterised by a willingness to ask challenging questions and back our judgement with conviction.
NEW BEGINNINGS VS FALSE DAWNS
Our investment decisions reflect this approach. In 2018 we visited Uzbekistan, a year before its first bond issuance. President Mirziyoyev had come to power on his predecessor Islam Karimov’s death, and we had been encouraged by some of his actions, such as releasing political prisoners and tackling forced labour in Uzbekistan’s cotton industry. Although Uzbekistan scored badly on several ESG indicators, our visit confirmed that the commitment to reform was genuine. We use milestones to monitor each investment relative to our hypothesis and with several positive milestones hit we remain impressed by the pace of Uzbekistan’s progress. Uzbek bonds proved relatively resilient during the pandemic, and currently the dollar bonds yield more than double similar maturity US Treasuries, which we see as a healthy source of income for our clients.
In contrast, while we invested in Ethiopia with a similar thesis – that Prime Minister Abiy Ahmed’s reforms would drive the Ethiopian economy forwards, helping lift millions out of poverty – we became increasingly worried that rising tensions between Ethiopia’s ethnic groups were unlikely to be resolved peacefully, and therefore progressively sold our holdings between July 2019 and June 2020. This action was the result of our qualitative analysis of governance factors, even though generic quantitative ESG data was stable. Indeed, the last year saw an escalating civil war and humanitarian crisis and the price of Ethiopia’s 2024 bond has fallen by 20 per cent as debt restructuring now looks likely. Looking beyond the off-the-shelf data and owning the ESG enquiry process is, in our experience, essential.
Ultimately, in-depth forward-looking ESG analysis can uncover both great investment opportunities and potential risks, helping us deliver resilient income while channelling funding to countries that can use it to improve the lives of their people. We believe this is the right way to invest in emerging market debt, one which can deliver great investment outcomes for clients who share our purpose.