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ESG analysis is fully integrated into the investment process of Robeco’s Emerging Debt strategy. Over the past years this analysis has given us valuable information in the selection of countries in which to invest. The differences in ESG profiles are quite substantial between emerging countries and changes can happen quickly.
ESG related issues have played an important role in the returns of emerging debt in the past and will continue to do so in the future. The large corruption scandal and political crisis in Brazil and the increasing grip of the Turkish government on society are recent examples. Looking back in time the list is much longer.
The Emerging Debt strategy has benefited greatly from being an early adopter of an ESG approach at country level. For instance, this helped us in avoiding investments in debt from a wider range of countries that have run into problems, such as Egypt or Ukraine.
ESG has become a main building block of our sovereign country allocation framework. The active country allocation in Robeco Emerging Debt is based on a combination of top-down and bottom-up analysis. In the bottom-up analysis, we focus on three key areas: debt sustainability, ESG and the macro economic cycle. In our top-down approach, the strength of ESG country analysis lies in its structured approach. By consistently monitoring ESG data, of which most are not available on a Bloomberg screen, we can identify country specific risks and potential investment opportunities at an early stage.
We have anchored ESG factors into our investment process via the RobecoSAM Country Sustainability Ranking. This ranking evaluates 62 countries – among which 42 emerging markets – on a broad range of Environmental, Social and Governance factors that we consider to be relevant from an investor perspective. Ranking data are available for all countries with a functioning bond market. They include ESG data that one probably would expect, like policies on greenhouse gas emissions, human rights and corruption, but also non-traditional angles like investments in innovation, labor market unrest, or aging policy.
Changes in the scores and the resulting ranking act as a flag for developments that could be relevant. This is the starting point for further research, which could influence our investments in a country.
In addition to evaluating countries around the time of the ranking updates we discuss the individual countries on a regular basis, to identify material changes in their ESG profile. Obviously ESG information only plays a role in investment decisions when deemed relevant. ESG is not the only criterion. Furthermore, our Country Sustainability Ranking is updated twice a year. In our decision making process we can take more timely information into account.
The ranking and changes in the ranking do not just identify risks. They also help in the search for investment opportunities for the Emerging Debt strategy. By taking changes in the ranking into account (and not only the ranking itself) we acknowledge the efforts to improve in the fields of E, S and G, although the effects may only be visible after some time has passed. After all, tackling sometimes long lasting issues require effort and often hurt some vested interests before bearing fruit. By investing in these countries instead of avoiding them, investors can profit from investing in countries where improvements in for instance the social climate take place, rather than wait until these efforts have already lifted the country to the level where it is ‘best in class’.
In an effort to quantify the impact of ESG factors on investment returns, Robeco’s Johan Duyvesteyn and Martin Martens, and Erasmus University Rotterdam’s Patrick Verwijmeren have investigated the relationship between changes in political risk, which is an important part of our ESG database, and changes in emerging debt returns over a period of 25 years. The results of this study have recently been published in the Journal of Empirical Finance as one of the few academic articles on ESG and government bond returns (Political risk and expected government bond returns, Journal of Empirical Finance, September 2016). The authors conclude that bonds from countries with an improving political risk climate tend to generate higher returns than those of countries in which political risk is deteriorating.
The way ESG integration works in practice for Robeco Emerging Debt is probably best explained by a concrete example: Brazil. From 2012 to 2015 Brazil suffered from a large setback in the Country Sustainability Ranking. The economy has been engulfed by a deep recession and the political climate was polarized by the corruption scandal at state-owned oil company Petrobras and the impeachment against president Dilma Rousseff.
The rapidly deteriorating ESG score has helped us in determining our stance on Brazil. The Emerging Debt strategy was underweight the Brazilian real during the second half of 2015 and early 2016. In government bonds the strategy had a modestly underweight position. In the second quarter of 2016, it became clear that a change of government would take place. The political risk score for Brazil (PRS data) improved again after having reached a low in March. By that time much negative news was reflected in the prices of the currency and bonds. Since the second quarter of 2016 we are no longer underweight Brazil.
Another example is the continued decline in the ESG profile of Turkey, which was one of the reasons prompting us to reduce investments in the Turkish lira. Over the years ESG analysis has given us valuable information in the selection of countries in which to invest. Quite often there is a direct link between investment returns and changes in the ESG profile of a country. For us it is clear that ESG information matters.