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Forecasting funds’ stability with ESG: A new gauge to consider

28/02/2019
funds
Equities
ESG
Investment
Making choices today that impact our tomorrow.

Key Takeaways

  • In recent years the fund industry has introduced a new gauge: ESG – Environment, Social and Governance – for fund holdings as a supplement to traditional financial gauges (historical returns, dividend payouts and volatility) when picking funds
  • Sustainable investing is a recent strategy that the fund industry advocates. Thanks to technology like Big Data, fund houses can index and score the ESG performance of corporates by setting quantifiable and objective measurements
  • On HSBC’s platform, most of the equity funds and multi-asset funds have a sustainability rating. Europe multi-asset funds and Taiwan equity funds are mostly rated as Category Five while some Japan and Asia equity funds have a lower rating

Investors often look for long-term and sustainable returns when investing in mutual funds. In recent years the fund industry has introduced a new gauge: ESG – Environment, Social and Governance – for fund holdings as a supplement to traditional financial gauges (historical returns, dividend payouts and volatility) when picking funds. Investors can reference the Sustainability Rating established by fund rating agencies as a quantifiable measurement to assess the ESG performance of funds and make a forward-looking investment.

ESG as a risk management strategy

  • Occasionally, there are headlines about corporate incidents that lead to environmental damage or loss of life and properties, or unethical business practices which bring negative impacts to goodwill or penalties from the regulators. Funds may hold these stocks due to valuations or growth trends. Recently, more funds are considering ESG in their investment process as a risk management strategy to manage these risks.
  • As of last year, assets under management in ESG funds globally have risen 60% over six years to over US$1 trillion, according to Morningstar, the fund researcher. While over 60% of the capital came from Europe, ESG funds in the US attracted nearly US$5.5 billion in net inflows last year, at a time when both equity and bond funds registered net outflows. This indicates that ESG strategy has become a new investment trend.
  • ESG has a wide range of issues – data protection and privacy, employees’ equal opportunities, product safety and quality, checks and balances on the independence of management boards, internal audit systems, energy efficiency, waste management etc. All these factors will determine a company’s goodwill, cost of capital and also its ability to resist external factors. Companies that perform well in ESG can boost their business value and hence lower risks triggered by corporate governance issues or environmental regulations. ESG strategy is therefore more than just “charity” to fund investors.

Considering ESG in the investment process

  • Sustainable investing is a recent strategy that the fund industry advocates. Thanks to technology like Big Data, fund houses can index and score the ESG performance of corporates by setting quantifiable and objective measurements. Generally speaking, fund managers would exclude companies from industries such as tobacco, firearms and so on, and select high quality bonds and equities according to their ESG scores. Companies with higher ESG scores would be over-weighted and those with lower scores would be under-weighted. With ESG complementing traditional financial data, funds could strive for a better alpha.
  • The industry has yet to develop a standardised measurement to gauge the ESG performance of different companies, but most fund houses publicise their ESG investment logic. Thematic funds that are related to sustainable investing normally provide more details on how the funds carry out their ESG strategy and also gauge measures such as carbon intensity indices for reference. At the moment there are over 20 sustainable investment funds authorised for individual investors in Hong Kong, including green bond funds, new energy funds, climate change funds and low-carbon equity and bond funds, according to data compiled by the SFC.

Assessing funds’ ESG performance by Sustainability Rating

  • With the increasing awareness of ESG beyond sustainable investment funds, fund rating agencies also rate the ESG performance of equities and bonds that other general funds are holding and establish the Sustainability Rating for funds. Ranging from Category One to Five, funds rated as Category Five score most highly in ESG among peers. 
  • On HSBC’s platform, most of the equity funds and multi-asset funds have a sustainability rating. Europe multi-asset funds and Taiwan equity funds are mostly rated as Category Five while some Japan and Asia equity funds have a lower rating. Taking Chinese equity funds as an example, the 10-year average returns of funds that are rated as Category Four range from 11% to 13%, about a percentage point higher than their peers. The volatility over the past ten years is also lower. Investors should look for the rating of a particular fund on the websites of fund rating agencies. Distributors are not showing the ratings yet as the concept is still at the development stage.
  • Since ESG is a long-term investment strategy, a fund that is top rated in sustainability does not necessarily lift the net asset value in the short term. By referencing the sustainability rating, the returns for long-term fund investors could have more protection by lowering risk factors. It is believed that capital in Asia will eventually flow into sustainable investing as it has in Europe and the US.

Source: HSBC, Morningstar, data as of 18 February 2019.    

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1Number of bonds / CDs available on HSBC’s online platform as of 22 February 2019

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