Case study by Grantham, Mayo, Van Otterloo & Co. LLC

In the spirit of showcasing leadership and raising standards of responsible investment among all our signatories, we are pleased to publish case studies of all the winning and shortlisted entries for the PRI Awards 2021.

Introduction: provide a short overview of the practice, process or product that is being proposed for the award

The GMO Emerging Country Debt team has incorporated ESG-related factors into its investment process since its founding in 1994. In recent years, the team sought to formalise its use of ESG metrics in sovereign risk analysis and bolster the consideration of ESG in its investment decisions.

The firm knew this task required an innovative and thoughtful approach, since its strategy has no explicit ESG mandate and is focused principally on generating alpha for its investors. Thus, simply skewing the portfolio towards countries with stronger ESG performance without consideration for other factors may not be supportive of that main goal, especially given that sovereign borrowers with better ESG scores also tend to offer lower bond yields.

GMO established three main principles to guide it: continuity (keeping the main structure of its investment process intact); relevance (creating proprietary ESG metrics directly connected to its asset class and investment approach); and performance (leveraging ESG data to improve its ability to analyse emerging sovereign borrowers).

The result was a rigorous econometric approach that allowed the firm to integrate ESG as an additional systematic risk factor, enhancing its ability to assess the countries in its portfolio and deliver alpha for its investors.

Process, practice or tool: Provide a description of the innovative approach to ESG incorporation, its coverage within your firm, why you decided to undertake this approach and the value it provided preferably using a practical example of how you have applied your approach to an investment (security/issuer/sector/asset class/portfolio)

The aim of GMO’s sovereign risk assessment process is to compare emerging sovereign borrowers to one another based on their fundamentals, aiming to identify which appear ‘rich’ or ‘cheap’ at any given point in time. The firm has traditionally approached this task by distilling various economic variables into three main systematic risk factor (‘pillar’) scores – Economic Structure, Fiscal Sustainability and External Liquidity – each of which contributes toward establishing a single score for credit quality.

Econometric analysis plays a large role. GMO’s analysts regress sovereign spreads on each of the sets of variables within each category which are ‘rolled up’ into a pillar score, before regressing sovereign spreads on the pillar scores to arrive at the final result. To meaningfully integrate ESG into this process, GMO elected simply to establish a fourth pillar wholly dedicated to ESG, such that the final score would be based on four broad categories of risk, rather than three.

This strategy allowed the firm to keep the structure of its approach intact and stay focused on alpha, but its execution was far from straightforward. Its first attempt involved the use of third-party country scores for E, S and G, which failed to materially improve the overall process’s performance. GMO’s analysts suspected this was due to the uniqueness of its asset class – that is, certain ESG-related phenomena might be more relevant to, say, equities markets than to debt – suggesting a one-size-fits-all approach may not be useful.

Thus, the firm then used granular ESG variables (eg. climate-related risk or infant mortality), coupled with its analysts’ own best judgment on assigning weights to each, and created its own E, S and G scores. Somewhat puzzlingly, this second approach performed only slightly better.

The final resolution was to rely on the econometric approach that is the backbone of the process itself. GMO let each granular variable’s statistical relationship to sovereign spreads determine its weight in the process, rather than relying on the analysts’ judgment. This approach proved much more successful and yielded much more robust results. GMO began testing a beta version of its new, four-pillar process in June 2020, and fully migrated in November 2020.

The case of the Bahamas serves as a useful example of the process in action. Previously the Bahamas’ sovereign debt appeared ‘cheap’, offering bond spreads significantly beyond what the fundamentals suggested. GMO’s analysts knew, however, that a good portion of this premium was explained by the country’s significant exposure to hurricanes and other climate-related risks, which were not explicitly contained within GMO’s systematic process at the time. The firm elected to be overweight, but knew the position entailed considerable uncertainty.

After GMO’s switch to an ESG-inclusive process, Bahamas’ score worsened, thanks in large part to the presence of climate risk within its environmental score. Yet, even as the country’s residual had narrowed, GMO felt more comfortable with its position, given that a significant source of uncertainty had been removed, and that the Bahamas still appeared to offer a significant premium.

This likely reflects a key area where GMO’s move to integrate ESG within its analytical framework has improved its overall process, namely by bringing certain matters that are critical to the measurement of sovereign risk from the qualitative to the quantitative domain, allowing them to be more accurately measured and assessed.

Outcomes, benefits, challenges and next steps: provide an example of the outcomes, outline the benefits and challenges associated with the introduction of this initiative and what you have learned from this approach that can be applied more broadly. How might you intend to develop the process or practice?

As mentioned above, one of the three core principles of GMO’s approach to integrating ESG has been generating performance. From the start, GMO has asserted that the presence of ESG in its process would need to do more than signal its hopes and priorities or satisfy a technical requirement for inclusion. Rather, it would need to advance its capacity to analyse the countries in its investment universe and thus help provide alpha to its investors. The results thus far have exceeded expectations in terms of performance.

In looking at the gaps between its modelled ‘fair value’ spreads for each country and their actual spreads, a majority of the most significant residuals tightened rather than widened, meaning the new, ESG-inclusive approach performed better than its standard approach in terms of assessing country risk. Meanwhile, only a handful of countries flipped from looking ‘cheap’ to ‘rich’ and vice versa, meaning the change in approach did not bring about a dramatic shift in directional results. GMO finds this outcome highly encouraging, as it provides strong evidence that ESG can be involved meaningfully in sovereign credit analysis without compromising returns.

Going forward, GMO sees enormous opportunities for further research on ESG and sovereign risk, highlighting two areas in particular. The first is how ESG factors – or trends in ESG factors – might be predictive of future sovereign credit returns, rather than current spreads. While GMO believes its static, cross-country approach is appropriate for its buy-and-hold investment philosophy, further investigation into the dynamic relationship between countries’ ESG performance and sovereign credit returns is worthwhile.

The second is how ESG factors might influence sovereign restructurings (that is, what happens after countries find themselves in default). Analysis of default recovery values often tends to, quite sensibly, centre on pure fiscal and economic considerations. Nonetheless, the relevance of ESG factors deserves exploration. What is the level of likely policy continuity from one governing regime to the next? How strong is a country’s level of social cohesion and trust? What is the risk that environmental catastrophe might suddenly change countries’ ability to service debt? These issues matter for default recoveries and warrant further investigation.

Lastly, significant challenges and opportunities remain relating to engagement and impact. Somewhat counterintuitively, GMO believes its approach – which establishes ESG metrics through an econometric process, and thus on the basis of how the world is versus how we wish it to be – can be a powerful tool in this regard. Emerging country debt investing lends itself naturally to engagement, not only with governments seeking to build their cases as sovereign borrowers but also with multilateral institutions. GMO believes its framework is well equipped to deliver feedback to both national policy makers on the ESG performance of their countries as well as to international policy makers on the key ESG-related findings of its analysis, with the latter having the potential to powerfully influence rules and standards at a global level.