How Investors Can Identify ‘Policy Black Swans’ in China and Elsewhere

When it comes to environmental, social, and governance investing, regional context is imperative, according to Rayliant Global Advisors’ founder Jason Hsu.

ESG initiatives allow investors and managers to reduce their exposure to regulatory risks by avoiding companies that may not align with local policy goals, organizations Hsu called “policy black swans.” But in a recent blog post, the Rayliant chief investment officer argued that the ESG issues that plague one part of the world may not extend to another.

For instance, in China, where Rayliant is focused, major social issues include unaffordable housing prices and a low birth rate. While investors in Chinese companies may see great value and regulatory risk aversion in implementing strategies that combat these issues, investors in Western companies have little use for the strategies. And vice-versa. 

“I realized ESG has to be quite localized,” Hsu told Institutional Investor. “You have to think about what the social issues are that really matter, because those are more likely to be issues that regulators act on right now. If it’s a social issue that only exists in the U.S. and not so much so in China, trying to apply that to China really wouldn’t help you reduce any kind of policy risk or give you any sort of policy benefit.” 

Instead, for example, investors in the U.S. may want to place a greater emphasis on values like racial equity. As a result, Hsu proposed that investors “localize” their ESG initiatives, meaning they should align ESG alpha generation with government policies that aim to reduce harm for local populations. 

While Hsu acknowledged that some issues are inherently globalized, he challenged investors to look at their ESG initiatives with a critical lens, not a necessarily Western one. “On the philosophical side, ESG investors have a more interesting question to ask themselves: Is ESG investing about divesting from companies that violate Western values, or is it about divesting from companies that cause the greatest harm to the local population and society? Investors may find these two are rarely the same,” he wrote.  

Hsu’s professional background, including a doctorate in finance from the University of California Los Angeles, is in quantitative investing. He has developed a number of approaches for incorporating ESG-related factors into quantitative products, and said he was among the first few people to introduce ESG-related products in Taiwan.

In 2016, Hsu founded Rayliant, which currently manages $27 billion in equity, fixed income, and alternative strategies. Based on conversations with asset manager clients, Hsu said most managers are motivated to incorporate ESG initiatives into their portfolios for risk reduction. For this to happen, Hsu said investors need to take into account the context of the region in which they are investing, a mindset shift that requires a major pivot in the industry. 

“ESG is the right direction,” he said. However, Hsu added, some firms use ESG as a means of deeming their specific values as universal and all-encompassing. Firms or economies then score other institutions according to their own hyper-specific scale — an attitude that, according to Hsu, erodes the purpose of ESG investing. 

“The original intent is to generate capital return that will also create benefits for society by encouraging firms to do the right things: It’s not meant to just embarrass another country,” he said. 

In order to generate successful results in ESG investing, Hsu said investors and firms must strike a balance between the “invisible hands” of the free market and government policies.