Introducing a new policy for assessing country-related risks

Fiduciary duty has many angles. One, of course, is to make sure our clients earn the returns that they need to meet their obligations to their members. Another is to manage risk, both financial and non-financial, including reputational risk – something that is increasingly important to pension funds in the age of responsible investing, and acute whilst we have a war on European soil. At Kempen, we believe what lies at the very core of fiduciary duty is endeavoring to do the right thing. With this in mind, we’ve been working on a framework that helps us decide which governments we are willing to trust with our clients’ investments.

 

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The pensions world – and indeed the broader investment world – has essentially sleepwalked into their exposure to the Russian Ukraine war. War as a real and near-term geopolitical risk between major economies was thought to be too far-fetched. But beyond the immediacy of war, there is a broader problem of investors having exposure to government which treat their own society poorly to an alarming degree, and we would say unacceptable degree. 
Kempen designed a framework scoring each country in our universe for a range of E, S and G factors which fit the values we believe are core to our clients’ beliefs, and their underlying beneficiaries. 
In this podcast we discuss the necessity of having such a framework and how it can help investors to engage on the governance of a major country.
 





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The need for action

The pensions world – and indeed the broader investment world – has essentially sleepwalked into their exposure to the Russian Ukraine war. War as a real and near-term geopolitical risk between major economies was thought to be too far-fetched. But beyond the immediacy of war, there is a broader problem of investors having exposure to government which treat their own society poorly to an alarming degree, and we would say unacceptable degree.; Most investors focus on the E of ESG and hence focussed on sustainability issues; investors (rightly) considered their exposure to private companies and their governance issues but ignored governments themselves; investors should be willing to place their values on social and governance within their investment frameworks just as strongly as they have done so with other issues.

Russia’s invasion of Ukraine has reconfirmed our thinking around a broader framework in which we would endeavour to decide which governments around the world were acceptable to be tied to through the investment world -   we believe there has to be a better way to choose which governments to include in our portfolios rather than just investing in them because they’re in an index. And it is necessary to have such a framework, because unlike with private companies, it is difficult if not impossible for investors to “engage” and have meaningful success on the governance of a major country.

Excluding sovereign issuers with questionable practices
We’re bringing forward the implementation of a new policy in which we will exclude the sovereign bonds of certain countries involved in egregious fails in E, S or G matters (or indeed more than one), such as human rights abuses,  persecution of sections of their populations, endemic corruption or materially derailing the global alignment to the Paris goals. This framework will sit on top of the regulatory restrictions on dealing with certain countries as enshrined in sanctions list – we are aiming to identify those which are ‘permitted’ for investment, but that we think ought not to be.

We’ve designed a framework scoring each country in our universe for a range of E, S and G factors which fit the values we believe are core to our clients’ beliefs, and their underlying beneficiaries.

  . Environment and climate: countries that cause serious damage to biodiversity, contribute to deforestation and/or cause severe CO2 emissions without a plan to address these issues.

  . Social: countries that allow forced labour or child labour, do not pay a living wage and/or restrict labour rights.

  . Governance: Restriction of democracy, freedom of expression, freedom of the press and the right to property.


We’re scoring countries ourselves rather than using commercial sovereign ratings, which failed to spot the risks linked to Russia and include exposures to countries that should in our eyes automatically be excluded. The existing ratings only really focus on financial risk – is this country going to repay its debt? – rather than ethical considerations. They ultimately tend to have a bias towards prosperity – and whilst prosperity often follows the values that are typically common in the West, it is obviously true that there are countries that have prospered without sharing them.

This framework  applies to governments, not companies –companies are not (usually) responsible for their governments’ practices, but we will also avoid investing in government-owned companies in countries that don’t pass our screens. We will continue to work with companies via our usual framework, believing that engagement is more effective than exclusion

A new way of investing in sovereigns with limited impact on investment returns
In the past, we’ve just accepted governments for what they are, judging only whether they are likely to repay their debts. You can’t really engage with governments, however big an investor you are, so either you’re comfortable taking exposure to a government or you aren’t. And whilst that decision has historically been anchored by financial metrics of their ability and willingness to repay debts and follow through on their financial promises, today this seems like it is just not enough.

The framework – unsurprisingly – is anchored by values which have become largely common to the so called Developed World (which in itself is an extension of the post-WWII West). Whilst this is an implicit bias, we do not think it is an inappropriate one. No developed markets fail our screens at present (though some are disappointingly low scoring), but around 30% of local currency emerging market debt issuers are screened out and nearly 50% of hard currency (USD or Euro denominated) emerging market sovereigns. These include major economies like China, Brazil, Saudi Arabia (and had the framework been applied, Russia).

Of those governments excluded, the one that matters most to investors should be China – which has become a darling of the government debt universe in recent years given its enormous financial strength relative to the rest of emerging (and indeed developed) world, and the yields available on its debt. Yes, we are willing to exclude an asset with a high risk adjusted return; ultimately, the total portfolio exposure to China is small, and the portfolio can be easily adjusted to find other sources of returns without a meaningful impact on total risk.  

The new policy does not seek to punish all emerging markets. Our investment decisions will continue to support developing economies, however, will do so with the additional objective of encouraging responsible regimes. Our framework enables continual measurement, meaning that if a country adjusts the way it operates, it will move up and down our ratings accordingly. It will be possible for countries that have been screened out to be reincluded if factors change.

While we expect the implications for overall pension portfolios will be manageable, the new framework will have big implications in terms of closely aligning the values of our investors, including their members – not just the trustees – with what the pension fund is doing.

What’s more, we’re implementing these policies with our underlying managers (often our existing managers), seeking to create new funds and pools of assets managed according to our criteria. With more than €100bn represented by our clients, we don’t have to accept the limitations of indices or encounter much resistance from fund managers to make the extra effort for our clients.

Endeavoring to lead the way
While our new framework is starting with government bonds, we’re going to consider how we can expand it over time and integrate it with our existing exclusion criteria covering all asset classes, including stocks and alternative asset classes.

Our new framework isn’t going to be perfect straight away, and we expect to make enhancements over the years. But we believe it’s an important starting point as we seek to lead from the front in terms of safeguarding our clients’ assets. As ever, we will endeavour to do the right thing and won’t shy away from the challenge. Our hope is that other asset owners and asset managers will follow our lead and implement similar frameworks to align their capital with the investment beliefs – and values – of the ultimate beneficiaries they seek to serve.

This content is only relevant for Fiduciary Management UK 

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