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Can ESG Reduce the Risks in Emerging Markets?

Environmental, social, and governance (ESG) screening methods have begun to take the investment world by storm as investors look to build portfolios according to their principles. And while there are numerous methods for adding ESG/SRI screens to a portfolio, the process is generally straightforward. That is, when it comes to the developed world.

For emerging markets, the process might be a bit more difficult. However, the rewards might be greater.

The truth is that ESG investing could lead to better returns as well as less risk in emerging and developing market stocks. With investment managers now turning their ESG attention toward the developing world, investors may finally be able to invest with confidence in high-risk stocks.

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Putting the ESG in Emerging Markets

These days, ESG screens are a bit more complicated than when avoiding tobacco, firearms, and other ‘sin’ stocks was the norm. Despite this, once a framework is developed for ESG screening, it becomes relatively easy to weed out the bad eggs from the good when looking at S&P 500 or MSCI EAFE Index. We can quickly determine if a firm like Coca-Cola or Nestle meets screening methods, assign ratings, and proceed. It’s easier to push for changes as well, given the ability of proxy voting, management meetings, and other activist techniques.

For stocks in China, Poland or Peru, this simple screening may not be enough.

By definition, emerging markets are, well, emerging, and that means they are just beginning their economic journeys. That’s generally the reason for owning them in the first place: they offer plenty of untapped potential. But with that untapped potential comes a host of problems. However, ESG can tackle these problems.

For example, environmental concerns and regulation might not be up to snuff in many of these nations. The majority of emerging market countries have relied heavily on fossil fuels like oil and coal—just like the developed world during their industrial phases—to fuel their economic growth. Nonetheless, this isn’t without consequence. The United Nations pegs that 92% of the Asian and Pacific population is exposed to air pollution, which comes with significant health risks.

Corporate governance can also be a headache when it comes to EMs. High insider and family ownership stakes can result in fewer internal controls. Bribes and kickbacks are sometimes part of normal business routine, while accounting standards across the world are different. Social factors can also be a problem, with different governments having different levels of ‘freedom’ and rules.

To that end, it takes a different and more active approach to applying ESG to emerging nations. It’s not just looking at a corporate level; ESG managers need to also focus on the nation and region-level when applying screens. Looking at all sorts of factors—from what a nation is doing to help its environmental standards and ending corruption to how it conducts elections—needs to be included in the analysis. At the same time, a different set of criteria needs to be applied to individual stocks within this framework. The one-two punch is how ESG can succeed in the developing world.

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Better Returns

But the legwork may be very well worth it. According to a meta-study by asset manager Schroder’s, applying ESG techniques to emerging market nations since the 1970s results in “positive impacts on corporate financial performance.” Better still, the following chart from Schroder’s study shows that the impact of ESG in emerging markets provides better corporate performance than for developed nations. In essence, focusing on ESG in emerging markets is more valuable for investors than doing so in the developed world.
positive impact of esg in emerging markets

Source: Schroder’s

As for actual numbers, the MSCI Emerging Markets ESG Leaders Index has managed to outperform the regular MSCI Emerging Index every year since its launch in 2008. Better still, the index has managed to produce positive returns when the broader non-ESG index has produced negative returns. Moreover, the ESG focused index has done so with less risk and overall volatility.

Making an ESG Play in Emerging Markets

Like the developed world, the number of opportunities for investors to apply ESG methods to the emerging world is growing. These days, Wall Street continues to launch new products and funds designed to take advantage of the ESG potential of emerging market nations.

Due diligence is key. Just as the developed market focused FlexShares STOXX US ESG Select Index Fund (ESG) and SPDR S&P 500 Fossil Fuel Reserves Free ETF (SPYX) track different ESG indexes/themes, the same can be said for many emerging market ETFs and funds that cover ESG. Investors and advisors need to focus on the funds that align with their goals and risk profiles.

Additionally, index versus active management styles need to be considered. For example, the iShares ESG Aware MSCI EM ETF (ESGE) takes a passive approach, while the GS ESG Emerging Markets Equity Fund (GEBIX) is actively managed. Given the additional needs of ESG in emerging markets, actively managed funds could be the best way to get the edge.

The Bottom Line

ESG in emerging markets makes sense. Data and evidence show that adding the screening technique to developing nations can provide a much better return sequence with lower risk. Now, with the number of options growing for ESG adoption in a portfolio, investors have the ability to use the investing strategy to its full potential.

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Nov 23, 2021