Responsible Investment in Emerging Markets and CalPERS’s new 8 principles in EM

In Kuala Lumpur a few thousand airmiles ago, my feature presentation on Responsible Investment in Emerging Markets covered three segments, firstly the State of RI in EM, secondly the Future of RI looking to 2012, and finally the Challenges and Opportunities for RI in EM thru 2012 by invitation of The International Corporate Social Responsibility Conference 29th-31st July, 2008. The state of RI in EM in 2008 reflects the broader RI movement history. Responsible investing has grown over the past 30 years in piecemeal fashion driven by issues – think napalm, apartheid, SOX and NOX, Darfur - and waves of investors from institutional and retail segments, as Steve argues in our forthcoming paper [Lydenberg & Sinclair, forthcoming Journal of Business Ethics, 2008]. Indeed, sometimes the changes at micro level are curious - one SRI fund tracked out of Boston (Dreyfus Third Century-DRTHX) has been seeing big inflows these first weeks of August. The main focus of RI has been and remains on equities - the stocks of large, publicly traded corporations. This emphasis on equities is perhaps accounted for by the emphasis within the early RI movement on changing corporate behavior in positive ways and the desire of religious investors to avoid companies involved in morally questionable lines of business. It also skews away from where much of the ESG investor action in EM happens, in fixed income, family-owned small/medium enterprises [SMEs], and company capital projects.

Malaysia has since 2006 required all listed companies to report on their corporate responsibility policies and programs to Bursa Malaysia, the Malaysian Stock Exchange, and the Malaysian Treasury has been active in describing listing CSR requirements. But listed equities always only form a small portion of economic and business activity, especially in SE Asia where family wealth and private companies, as well as parastatal companies, form a major component of capital ownership and business activity. If sustainability or CSR aims to cover more ground, asset classes from the investment horizons outside of equities must be covered. Currently we are scoping a more comprehensive view on private equity and high net worth investor activity.

Demand for ESG in investment analysis coverage in developed countries has led to increased and improved supply [off a nothing base]: mainstream investment houses, such as Société Générale, F&C Asset Management, HBOS, Citigroup Smith Barney, JP Morgan Chase, Merrill Lynch, UBS and Goldman Sachs have in recent years established in-house research teams that conduct analyses for their investor clients on such issues as climate change, renewable energy, water, human rights, nutrition and diversity. Some of it is eased along by the Enhanced Analytics Initiative [EAI], but as a mate reports even this year in 2008, the EAI offering for EM investors is thin. I agree with Marcel Jeucken of PGGM, the second-largest Dutch pension fund, that there is “low hanging fruit in EM from an ESG perspective” [Responsible Investment Landscape Report: Asset Managers, 2008]. PGGM considers EM from a human rights perspective including covering “oppressive regimes” [undefined], and they reportedly cover fully 1,000 EM companies of the 4,000 companies universe screened. EM is sometimes regarded as an illiquid asset class, based on the volatility and some settlement challenges.

Direct and Indirect

In my EM session, one sensed the audience leaned forward when I covered the roles of investors within a country and into a country, foreign versus local capital, a truth in tension in EM. The 1997 Asian currency meltdown was a “where were you when…” moment in the region’s history ["Soros" remains a four-letter word]. The ‘97 crisis, as one local expert explained; “took away not just the investor focus and funds but internal drive as well”. What foreign investors think, and do, is important to Malaysian investors. Today the regional rivalry with Indonesia, Singapore, Thailand and similar countries is real. The conceptual framework I developed for the PRI in EM Project [now being taken on by my former intern, Narina Mnatsakanian, recruited from KPMG Netherlands] on investors directly or indirectly into EM was usefully adapted for the Malaysian presentation.

The graphic [see above] illustrates the role of portfolio flows in EM, and three points of investor exposure – including the third category where GE fits in, noting that for the first time ever, in fiscal 2007 more than 50% of GE’s revenue came ex-USA. Going forward, the relative power of family wealth, private companies and company capital investment including M&A must be factored into the thinking. The EM Investor framework explains the relative roles of foreign portfolio, local portfolio as well as company supply and demand chains across borders into EM. For example, in February 2007 California Public Employees’ Retirement System [CalPERS] committed US$400 Million to a new private equity vehicle focusing on global emerging markets in Eastern Europe, Latin America and Asia.

I explained our experience of ex-country investors sitting in San Francisco, London or Zurich who use a tool like the MSCI Barra EM Index as universe and benchmark for their EM exposure. The last public data had Malaysia represented 3.052% with $79,193 market cap and 58 companies, the ninth largest allocation and fifth of five ASEAN countries in the top 10. Malaysia is a major component of an EM perspective. The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets. The embargoed website lists the MSCI Emerging Markets Index as of June 2006 consisted of the following 25 emerging market country indices: Argentina, Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Israel, Jordan, Korea, Malaysia, Mexico, Morocco, Pakistan, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, and Turkey. In the UN context of course, Taiwan’s massive market cap [US$ 688bn at 31 Dec 2007] was wished away to cater to the China politics.

The perspective of foreign investors may be as influential as sovereign ratings agencies, and of course they are self-reinforcing. This week the price of South Africa’s long delayed electricity grid upgrades just got a lot more expensive when all three ratings agenices downgraded ESKOM debt, forcing the treasury to promise to underwrite it and the path to the World Bank to be trodden once again.

Eight Principles

In the institutional investment space, whatever US giant CalPERS does is watched closely, slightly less than more paparazzi friendly targets in California, like Britney Spears or Jack Nicholson… Noteworthy for EM investors, in December 2007 the CalPERS Investment Committee moved away from a negative-screening-on-country approach in existence since 1989 toward a new principles-based approach to investing in the emerging markets in lieu of the existing country list and permissible equity market analysis adapted from the FTSE All Emerging Index [evidence of CalPERS market power and the competitive nature of the index business that they chose not to use the industry de facto standard, MSCI EM Index]. Apparently, the time and resource costs out-weighed the ESG benefits - former CalPERS analysts admitted the policy consumed hundreds of hours of staff and consulting time. In April 2007 when the review was announced, Mark Anson — CalPERS’ former chief investment officer and then chief executive officer of Hermes Pensions Management Ltd., London [he returned stateside a year ago citing personal changes], wrote in an e-mail to Pensions & Investments “I am encouraged by statements of Chuck Valdes and other board members to review the emerging markets policy. Emerging markets are the most dynamic part of the equity markets, where change is rapid and investors must be both prudent and flexible to achieve the best possible long-term returns.” Media also reported the emerging markets list had cost the fund 2.6 percentage points annually in performance — or $401 million in opportunity costs — from Aug. 1, 2002 through Dec. 31, 2006. Together with busloads of citizens from targeted EM countries, clearly an unwieldy but well-intentioned effort that attracted debate over the years, as far back as 2002.

The new approach, GLOBAL PRINCIPLES OF ACCOUNTABLE CORPORATE GOVERNANCE, was reported by Cal PERS as “continues CalPERS’ policy of being a positive influence for improved practices in emerging markets, while increasing the opportunity set for CalPERS’ managers”. The eight principles cover a mix of ESG factors, including the major of political institutions, illustrating a delicate crossover of investor and the public sectors [extracts below]:

· A. Political Stability – including what I rate as the more important factor, Civil liberties: 3. Independent judiciary and legal protection:

· B. Transparency – including elements of a free press necessary for investors to have truthful, accurate and relevant information [biggest ticket item for me] and stock exchange listing requirements [more on the Brazilian experience at BOVESPA next week].

· C. Productive Labor Practices.

· D. Corporate Social Responsibility and Long-term Sustainability - Includes Environmental sustainability and the Global Sullivan Principles of Corporate Social Responsibility [see new website at http://www.thesullivanfoundation.org/gsp/default.asp].

· E. Market Regulation and Liquidity – including “little to no repatriation risk”.

· F. Capital Market Openness .

· G. Settlement Proficiency/Transaction Costs

· H. Appropriate Disclosure

The document introducing “The Global Principles of Accountable Corporate Governance” describes the framework by which CalPERS puts into action its proxy voting responsibilities in addition to providing a foundation for supporting the System’s corporate engagement and governance initiatives. The aim is “to achieve long-term sustainable risk adjusted investment returns”. It is unclear how this objective will be measured, and over what time horizon. CalPERS does break new ground in developing their own approach that does not naively map to a smorgasbord of acronym international initiatives, similar to the Fins and Danes. CalPERS also offers some material on their universal owner perspective, namely “[CalPERS] has chosen to adopt the term "shareowner" rather than "shareholder." This is to reflect a view that equity ownership carries with it active responsibilities and is not merely passively "holding" shares. Perhaps the strongest takeaway for any investor is the quote from CFA Institute’s take on Corporate Governance: “For corporate governance structures to work effectively, Shareowners must be active and prudent in the use of their rights. In this way, Shareowners must act like owners and continue to exercise the rights available to them.” (2005 CFA Institute: Centre for Financial Market Integrity, The Corporate Governance of Listed Companies: A Manual for Investors)

How decisions on the eight principles are made, and indeed the relative weightings on decisions [for example, when would a country perspective on China trigger a review?], may reflect the pragmatism necessary in investment in general, and especially in ESG. I look forward to the first review of the new principles based approach next year, and comments from similar institutional investors I met this year in Singapore, Rio de Janeiro, Cape Town, London, New York, Boston and Dubai. As many before us have learned in sustainability+investment, the pragmatic trumps the politics.