The Responsible Investor
Category: Asia, Global
By David Macfarlane
Nikko Asset Management: Reclaiming the moral high ground
Asia Asset Management kick-starts its new regular quarterly segment – The Responsible Investor – by talking to Yu-Ming Wang, global head of investment and chief investment officer - international at Nikko Asset Management, about his firm’s commitment to, and belief in, sustainable and ethical investing.
Asia Asset Management: The importance of environmental, social and governance (ESG) integration in the investment process/ strategies – why and how?
Yu-Ming Wang: Financial services industries have been losing trust among the general population. Excessive risk-taking behaviour and Libor collusion scandals have thrown the ethical standards of the financial sector into question, especially since the financial crisis in 2008. The investment management sector is not exempt as consumers tend to group all financial subsectors under one umbrella. Areas of controversy include excessive fee charging, the focus on short-term returns at the cost of broader societal goals, and compensation schemes which incentivise misalignment of interest with clients.
ESG and responsible investing have been espoused as movements to align investing of capital with the promotion of corporate behaviour in sustainability and corporate social responsibility. But we at Nikko Asset Management take the stronger position that ESG, with its broader definition as responsible investing, should be the moral anchor for our industry.
True wealth is fresh air to breathe, clean water to drink, and fertile soil for growth, trust and peace. But we may have lost sight of this with wealth being created at rapid-fire speed in financial markets today. Just how sustainable financial wealth is if society loses the environment, social justice, or good governance is no longer a rhetorical question.
Emerging markets (EMs) such as China are already searching for a healthier balance from realising the painful trade-off between industrialisation and environmental costs. Developed markets (DMs) such as the US have seen the rise of populism due to income inequality. Companies in both developed and emerging countries are grappling with corporate governance issues to better align the interests of management, shareholders, and broader stakeholders. All of these issues directly impact the valuation of shares. Investors can and have the responsibility to influence how challenges are dealt with, because they impact the collective wealth of society.
Governance: In our opinion, good governance forms the bedrock of value creation. This connection is common sense and deeply rooted in the principal-agent theory in economics. The separation of ownership and control is arguably one of the best developments of modern capitalism, enabling the pooling of capital from diverse investors. This has, however, also led to issues of accountability, and control of management. Considerations such as executive compensation, defining a board’s duties, transparency and disclosure are important elements in framing the oversight of company management for the long-term interest of the owners. The mentality of long-term owners about good corporate governance is quite different to that of shareholders who trade in and out of a stock, or as part of a passive strategy. As such, engaging company management on long-term issues becomes necessary in order to understand the executives’ beliefs, strategy and execution, and evaluate corporate governance.
Social: Social impact can be difficult to quantify. Some examples of social factors are the relationship between labour and product safety, human rights violations, and child labour exploitation. To identify such risk factors requires a good understanding of the micro issues of a company’s operations, including manufacturing and vendor practices, marketing and selling practices, internal morale, and employee turnover. While not financial metrics per se, they are all inherently tied to an assessment of a company’s quality. By understanding how a company deals with social factors, and the relationships between the various stakeholders, a long-term investor can better identify the risks of financial or reputational disaster.
Environmental: The environmental factor in ESG often exists as an externality cost that companies and analysts may ignore because of the extent of the issue and its global nature. Environmental issues such as climate change, pollution and resource depletion matter to investors because such costs are eventually borne by all of society. For very large investors, the concept of universal ownership compels them to explicitly recognise all externalities as costs generated by one company borne by other parts of the economy. While each company may bear a small portion and not see the total cost, the total cost is actually a key driver of a company’s potential liability.
There are three ways to implement ESG: negative screening, positive screening, and full integration. At Nikko Asset Management, we employ full integration for active investors with the belief that engagement with the company is the best way to make a positive impact as an investor. This is possible because we are stock pickers, running relatively concentrated portfolios, with a long-term investment horizon.
How does the flight-to-quality in stock selection work through ESG, and how can investors protect themselves while assuming a risk-on mentality again when the market signals a recovery cycle?
As active investors, we think of ourselves as owners of quality enterprises for the long haul. We believe active responsible and sustainable investing leads to good capitalism for these reasons:
(1) When investors think long term and see themselves as owners of the business rather than just holding shares in a company, perceived contradictions between shareholder capitalism and global sustainability begin to disappear. In contrast, focus on short-term results and passive shareholding behaviour causes some of these conflicts.
(2) A good capitalist has to be a good citizen. Going back to the ideals of a civil society, every citizen has to mind the society’s common good as much as their own. When citizens stop caring about community affairs, civil society breaks down. When companies only care about shareholders at the expense of other stakeholders, corporate brand gets tarnished and values are destroyed. Responsible citizens lead to a thriving community, prospering company, and economy, respectively. Speaking up and engaging with other stakeholders are the most effective ways to create an inclusive community, company, and society.
(3) Caring about all stakeholders, thinking long term as a steward of capital, and being mindful of ESG issues influence the long-term value of an enterprise as much as financial matters. These elements are consistent with good common sense investing. Responsible investing for a sustainable future in itself is synonymous with good investing.
How would you describe the unique challenges of responsible investing in Asia, and what can the region learn from its European counterparts? What are the risks specific to Asia and how can responsible investing be used to safeguard investments?
The challenges of responsible investing in Asia stem from the emerging nature of most economies in Asia. This is not the same as associating Asian companies with higher ESG risks compared to DMs. Investing in EMs poses a different risk and requires a different ESG mind-set from investing in DMs.
One obvious difference is that many companies in emerging Asia are still controlled by founding families or the state. The visible hand of the majority shareholder may pose unique risks, such as corporate governance, to minority shareholders. Investors must carefully investigate issues such as alignment of interest, history of related-party transactions, dividend policy, and shareholders’ rights in order to fully understand if management is working for the minority investors as much as the controlling investors. This does not mean that investing in majority-controlled companies is automatically a bad idea; in fact, many entrepreneur-controlled companies have helped drive Asia’s economic growth and proven to be great enterprises to own for the long haul.
The flip side of Asia’s challenges is the Western model of extremely decentralised shareholding, where owners are far removed and management exhibits behaviour that runs counter to shareholders’ best interests. One such thorny issue which some US and European companies are struggling with is excessive executive compensation.
Is there a trade-off between principles and performance? Or can looking at responsible investment issues have a positive financial pay-off? Is there sense in sustainability – how is it possible to find growth in a low growth environment?
Sustainable investing and good investing are two sides of the same coin. In our view, it is less important to establish empirical proof that practising ESG leads to outperformance in the short run, because ignoring the principles of responsible investing will lead to value and wealth destruction in the long run.
There is an intrinsic connection between ESG and value creation. To understand the total enterprise when investing in a quality company, good financial and ESG analysis are required. Our investment solutions are consistent with good risk management and good compliance, but we do not label them as such. In the same vein, while we employ teams of risk and compliance specialists to support these important functions, the fund manager still owns and cannot delegate these basic responsibilities.
Sadly, the 2016 public trust barometer as surveyed by the CFA Institute and Edelman Project placed financial services below automotive and energy industries. The Gallup poll of public perception on various professions’ ethics listed bankers, business executives, and stockbrokers in the bottom tier. Large segments of society cannot distinguish between bankers, brokers, and investment managers within the broader fabric of the financial services category. Many think that investment managers, just like highly paid business executives, only care about financial returns (for their clients, their shareholders, or themselves), to the detriment of non-financial issues, which may bear critical, long-term impact on humanity. On the other hand, large asset owners and public entities with a large cross-section of the population as their beneficiaries have to care about broader socioeconomic factors due to pressure from constituents as well as policymakers.
This perception gap in the trustworthiness of our industry is real. We believe ESG presents an opportunity for the asset management industry to address this gap. By genuinely embracing the principles of responsible investing, we can reclaim the moral high ground as stewards of wealth for society.