ESG compliant companies provide superior returns

In terms of individual stocks, the top five stocks, comprising Public Bank, Maybank, Tenaga, CIMB and Axiata, account for 43.6% of the benchmark index.

THERE have been some arguments about the lacklustre performance of Bursa Malaysia’s benchmark KLCI and if we look at the performance of the index over the past five years, it not only has been poor but negative.

As we know, the 30-stock index represents Malaysia’s largest listed companies in terms of market capitalization and of course they are screened using the liquidity rule as defined by the index methodology and weighted based on their respective net market capitalisation, ie, after taking into consideration the free-float factors of each constituent.

Based on the KLCI index fact sheet as published by FTSE Russell and Bursa Malaysia, as at Jan 31 2020, the index itself is heavily weighted against selected market sectors, which among others include the financial sector at about 35.7% weighting, followed by food and beverage sector at 13.3% and the utilities sector at 12.6%. The three sectors alone account for about 61.6% of the index.

In terms of individual stocks, the top five stocks, comprising Public Bank, Maybank, Tenaga, CIMB and Axiata, account for 43.6% of the benchmark index.

We all know that the KLCI has not been performing well in the past few years due to its skewedness towards the top three sectors and the top five stocks, especially the finance sector.

Just like any other benchmark index for any stock market, what can investors do to move away from the underperformance of an index? There are several ways to tackle this issue. But before that, we must recognise the fact that the index is only relevant for relative performance measurement.

The problem in the investment world is that most fund managers are fixated with relative performance but in actual fact what is more important is absolute performance – everyone wants to make money and not just beating the index but to make sure that the fund manager is able to grow the fund size using his professional skills of stock picking and market timing. What’s the point of parking investible funds with a fund manager only to find out that while he has beaten the index in terms of his performance, but the returns for the year were negative. Hence, if investors are less fixated with the index, investors can gain positive returns by picking the right stocks.

However, with just 30 stocks in the KLCI, it does not properly reflect the overall market in terms of companies’ representation.

Better measurement

So, what is a better way to measure performance other than the KLCI? Well, there are few alternatives, one is to benchmark against other indices and this could include the widely followed global MSCI Malaysia Index. This index has 40 constituents and represents roughly 85% of the Malaysian market in terms of size.

We also have the other two benchmark index, but rarely talked about.

They are the FTSE Bursa Malaysia EMAS Index (EMAS), which is an index representing the top 98% of the Main Market constituents and the FTSE Bursa Malaysia 100 Index, which comprise of the KLCI and the FTSE Bursa Malaysia Mid 70 Index.

Well, all this may be confusing as there are just too many indices to comment about especially in terms of number of constituents and how they differ from one to another.

What is interesting is to explore potential benchmark index that investors could follow but at least mirror the KLCI to a certain extent. What it means here is that some investors want to be exposed to the market but not using the KLCI as a benchmark. Other than the MSCI Malaysia Index, another popular index that is gaining momentum is the FTSE4Good Bursa Malaysia Index (F4GBM). F4GBM is an index that is designed to capture companies within the EMAS index that meets the stringent Environment, Social and Governance (ESG) criteria.

This include companies that exhibit good corporate responsibility. Launched on Dec 22 2014, the F4GBM is a universe of the top 200 of the EMAS index and similar to the KLCI the ranking of the stocks in the index is free-float adjusted and screened for liquidity. Although the index universe is 200 constituents, as of the latest update, only 69 companies made the cut to be in the index. The next question is how different is F4GBM than the KLCI? Table 1 below provides a summary of ranking among the top 10 stocks of both the indices as well as which are the top three sectors in the two indices as at end of January 2020.

From Table 1, one can see that while if a constituent is member of both of the indices, the weighting of each of the constituent is not much different from either being ranked in the KLCI or the F4GBM. The differential is only between five and 18 basis point (bps). In addition, there is no difference in ranking among the top six index members, but within the top 10 in the KLCI, IHH and Dialog are not F4GBM constituents and in place, is Maxis and IOI instead.

Table 2 summarises the top six sectors within the two indices. In terms of sector classification, what is defined as Food and Beverages in the KLCI largely falls under the larger consumer sector in F4GBM Index while the other clear difference is that while Healthcare is the fifth highest rank sector in the KLCI, the sector’s presence in the F4GBM is much lesser.

Why is ESG investing gaining traction among investors? There are many studies done by the academia as well as anecdotal evidence that suggests ESG investing is the right way forward. Companies that are ESG compliant tend to behave in a more responsible manner, protect stakeholders’ interest in terms of governance structure and care for environment as well as community that a company serves. Issues related to bribery or financial scandals are mostly absent and rarely present while at the same time these companies tend to perform much better financially, less earnings volatility as well as lower cost of funds.

All this leads to lower stock beta and hence companies which are ESG compliant tend to outperform the market over the longer term. Is this true? Table 3 shows the relative performance of the KLCI and F4GBM between 2014 and 2019 as well as year-to-date performance up to 27-Feb. It is clear that F4GBM provides superior returns to investors, not only at times when the market was down, where F4GBM experienced a smaller contraction in the index as compared with the KLCI, but it also significantly outperformed the market when the market was on an uptrend. Only F4GBM performance in 2020 has lagged the KLCI as it has marginally underperformed by about 0.65 percentage points.

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ESG , compliant , companies , superior , returns , Pankaj Kumar , comment , KLCI , Bursa , FTSE ,


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