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Allan Lane, Algo-Chain

KraneShares’ new China ETF applies its ESG slide rule from Shanghai to Guangzhou – Look what happened

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As the rise of boutique US ETF providers continues to lap the shores of Europe, it is good to see Kraneshares making its mark with the launch of the KraneShares MSCI China ESG Leaders UCITS ETF listed on the London Stock Exchange last week, with ticker KESG and with an annual management fee of 0.4 per cent.

By Allan Lane, Algo-Chain – As the rise of boutique US ETF providers continues to lap the shores of Europe, it is good to see KraneShares making its mark with the launch of the KraneShares MSCI China ESG Leaders UCITS ETF listed on the London Stock Exchange last week, with ticker KESG and with an annual management fee of 0.4 per cent.

We are told by many managers that ESG is the new alpha. Actually, it turns out that it is the new beta, which in a world where socially responsible investing is undergoing an inflection point of interest, for some active managers that must be a difficult message to take on board. Given that the market share of active funds is under pressure, and all things ESG are on the rise, then it is entirely understandable that some individuals will choose to conflate the two topics. The brutal truth is that just as most active managers fail to beat their benchmark, that will remain true even if we restrict the scope to ESG qualifying assets.
 
This ETF is yet another case study of what it takes to compete in the high stakes game of passive investing. The founder and CEO, Jonathan Krane, made his mark having previously spent five years in Shanghai building up and then ultimately selling a media business. During that time, he witnessed first-hand the growth of what many commentators now dub the ‘new’ China, and before long Krane opened up for business in the US. Their US listings comprise 12 funds, three of which are listed in Europe, and not surprisingly are dominated by China motivated themes or strategies, my favourite being the One Belt One Road ETF, with ticker OBOR.
 
While the firm might be best described as a boutique, it is commercially backed by the somewhat larger Chinese entity CICC, the China International Capital Corporation, who hold a significant stake in the business. To this add the fact that the benchmark provider of this new China ESG ETF, MSCI, is itself no slouch.  Through the prism of an ESG lens, it is obviously the quality and sourcing of the data, that is an essential if the ESG ratings are to be trusted. At the index design stage of this ETF, one can see that having both CICC and MSCI at one’s disposal, starts to look like a very fortuitous marriage.

The index inclusion rules follow a framework that MSCI have refined over the last few years around their three pillar ESG rating methodology. This includes the exclusion of companies involved in Alcohol, Tobacco, Gambling, Nuclear Power, Conventional Weapons and Civilian Firearms, screening for stocks that have an ESG rating of at least BB, a minimum controversy score of at least three, and then topped off with a market-cap weighting scheme that limits the concentration risk across industry sectors.
 
When investing in emerging markets stocks, the benefits of an ESG screening process feels like a must do activity, but isn’t that what equity analysts do for their day job? All in all, this ESG fever that has taken the markets by storm, takes us back to the go-getting years when being an equity analyst was one of the coolest jobs on Wall Street. What’s new, as the saying goes, is that this time it’s different. There really are good reasons why it makes sense to challenge those businesses that are not up to scratch on the ESG front. 

Who can forget those dramatic TV images a few months ago in California when Greta Thunberg was interviewed against the backdrop of raging forest fires and burning buildings? To that add the very recent biblical comparisons of plague and pestilence as great swathes of China goes into lockdown mode to contain the Coronavirus. It is becoming clearer by the day, the world’s capital markets need to police themselves, and that investors in turn need to shun those businesses that are at odds with the greatest issues facing each and every continent.

When studying the holdings of this China ESG Leaders ETF, the issue of where an active manager might find a source of outperformance comes rushing back into view.  In the same way that Microsoft almost always appears in an ESG screened US Equity index, so it is with China and Tencent and Alibaba which are the top two largest holdings at 9.5 per cent and 9 per cent respectively.  So, it would be fair to say, there is no real ‘alpha’ opportunity for those managers engaging in stock selection, more a case of tactical bets by going over or underweight as suggested by their trading signals driven off their own proprietary data sets.  

Progressing down the full list, comprising 132 holdings, then with lesser known names like Sino Chem International and Tongkun Group, is this where the opportunities lie?  Given the transparency that comes with the excellent groundwork that MSCI have done, it is no easy job to beat the index.  Even if you are one of the world’s biggest quant funds, such as Bridgewater, then it is highly likely your investment team is not working off any better ESG-centric data sets than what is behind KraneShares’ offering.  To this add the annoying fact that Bridgewater’s alpha machine stuttered in 2019, when the S&P 500 soared.

As for the view that some managers will be able to outperform the benchmark, I am completely on board with that. If this happens, using this ETF as a case study, I suspect it will not be down to superior access to privileged ESG data. More a case of technique and the active manager’s ability to design a wider range of strategies involving the same set of selected stocks, while also managing the portfolio’s risk as one crisis after another in emerging markets resets the mould. 

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