The regulations in China are what took center stage for many investors when looking back at the year-in-review, and the mass exodus by foreign investors from many funds with China exposure is a sentiment that is continuing to linger. A recent paper from KraneShares, however, makes the compelling argument that it was these same regulations that will set China ahead in coming years, within ESG investing in particular.
Europe and the EU already have ESG regulations that were initially enacted in 2018 and which brought sweeping changes through industries, with ongoing regulations since. China began its regulatory work this year, with a large focus on the internet sector and aligning companies with social responsibility. The U.S. has yet to enact any broad regulations within ESG, although there is increasing focus on the tech sector and data privacy, particularly within social media and its target on children.
KraneShares has found that there appears to be a direct correlation between countries with regulations and the impact of ESG on performance. When comparing the MSCI standards to the ESG leaders indexes for the U.S., Europe, and China, the U.S. had the least amount of outperformance at just 4.3%. Europe’s success was more pronounced, with ESG boosting performance and outperforming the MSCI at 23.9%.
Image source: KraneShares
China had the greatest overall ESG outperformance at 102.1%, and when charting the years, the China ESG Index outperformed the broader index seven out of eight years since its inception in 2013. Europe outperformed seven out of 10 years, and the U.S. ESG Index outperformed five out of 10 years.
The U.S. has been a consistently broad outperformer this year, but with more legislative focus coming on the technology sector, such as the Instagram hearing before the Senate to discuss the negative impacts of the social media giant’s platform on children and teenagers, regulation is coming. On top of tech-related regulations, those regarding emissions are currently being bandied about, with the EPA proposing a serious limitation on methane emissions, and other carbon reduction commitments being discussed by Congress.
So what does it all mean? It could mean the looming potential for very serious restructuring by many industries within the U.S., on par with the restructuring that many companies in China have already undergone. China has undergone regulation regarding its technology sector as well as climate initiatives and is positioned to move forward and into growth, particularly within ESG, where it has already proven to be an outperformer.
Investing With Diversification in China’s ESG Leaders
The KraneShares MSCI China ESG Leaders ETF (KESG) invests in the leading ESG companies within China, and because of its sector diversification, it has been able to mitigate much of the regulatory risk within China this year.
The fund seeks to track the MSCI China ESG Leaders 10/40 Index, an index that is free float-adjusted and market cap-weighted and includes companies with high ESG ratings compared to their peers within their industries. The index includes all types of publicly issued shares from Chinese issuers from all market caps and screens out any issuers that have any controversies according to the UN Declaration of Human Rights, the International Labor Organization Declaration on Fundamental Principles and Rights at Work, and the UN Global Compact. The index also screens out any companies that are involved in alcohol, tobacco, civilian firearms, gambling, nuclear power, and conventional and controversial weapons.
The index is comprised of securities from the following sectors: consumer discretionary, industrials, financials, communication services, healthcare, real estate, utilities, consumer staples, information technology, materials, and energy. Securities included make up the top 50% market cap of their sector, and no single security can make up more than 10% of the underlying index, while no sector accounts for more than 40% of the index.
As of the end of November, sector allocations were consumer discretionary at 41.74%, financials at 14.57%, healthcare at 11.25%, and several smaller allocations.
KESG has an expense ratio of 0.58%.
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