EMs and ESG: Mutually exclusive?

This article is a part of Morningstar Canada’s ESG Special Report week 

Emerging markets are more volatile than developed markets, and also are riskier. However, they are a growing and significant part of global markets, and now represent more than 10% of global equity indices. A growing share of the world’s population lives emerging market countries, with China and India alone making up more than a third. These countries also have a younger workforce with a growing middle class and a consumer base that is getting wealthier.

It is a fact that opportunities abound in these markets, and they do outperform Canadian markets. But it is also a fact that these markets are often opaque and difficult to navigate. Investors approaching emerging markets face differences in technology, culture and regulatory environments. So why would you want to add another layer of complexity with an ESG (environmental, social and governance) screen on emerging markets?

For one, the alpha is there. The MSCI Emerging Markets ESG Leaders Index has outperformed its non-ESG emerging markets peer by roughly 3% at both 5- and 10-year annualized return marks as of August 30, 2019.

But is that enough to entice investors away from a home field advantage, and into the riskier world of emerging market investing? After all, any investment abroad faces “an entire spectrum of challenges”, according to John Bai, Chief Investment Officer at NEI Investments. For emerging markets investors, it’s about finding the diamonds in the rough. “In developing economies you’re dealing with less information, on a less-consistent basis” he warns.

One might consider an ESG approach better suited to developed economies, which have benefitted from the general trend of governance, oversight, regulation and corruption issues improving with GDP per capita.

However, though it may take a little more effort to find ESG investments in emerging markets, Bai says that it is definitely worth it. You may well discover some of the most ESG-compliant companies in the world in these markets, often at a discount. In fact, by entering areas more ESG-optional, you might find some of the best priced, purpose driven and long-term oriented companies out there.

“Because there is more variability in ESG disclosure, policy and practice standards across emerging markets, there are arguably more opportunities for investors to use ESG to differentiate between companies and pick the potential winners,” agrees Judy Cotte, CEO at ESG Global Advisors. “This is at least in part because the legal regimes don’t tend to be as strict or prescriptive, so the companies that take ESG seriously may have a strong understanding of its value, as opposed to just approaching it from a compliance perspective,” she says.

A risk and a tool

Emerging markets offer some of the greatest growth potential, with untapped and cheap energy, material and labour resources – but Bai says consumers are keeping a closer eye than ever on long-term, responsible governance.

“The world is moving to a better place,” Bai says, adding that “investors are keeping companies accountable – even if the regulations aren’t there.”

Governance is the most important of the three pillars of ESG in emerging markets, a panel at the Morningstar executive forum titled, “Is ESG a source of Alpha?” unanimously found, and also pointed out that companies with good stewardship and governance in emerging markets are the most likely to outperform and generate alpha.

Irresponsible investments anywhere present a real risk, in emerging markets as well, but at the same time, emerging market opportunities continue to grow.

The most attractive opportunities in emerging markets – and in the information age – can be part of multi-trillion dollar ‘megatrends’, says Bai, pointing to emerging markets propelled by new technologies, ‘leapfrogging’ generations of evolution and leaving societies with a double-edged sword of massive change.

“Take China and artificial intelligence,” says Bai, “you have big opportunities, but also risks around data privacy and facial recognition – you have to find out how these new technologies are being applied.”

There’s a particular need to separate risk from reward in emerging markets, but the public and prescribed route to gathering information on the responsibility of companies just isn’t reliable.

The problem of data

ESG and emerging markets are a complex and volatile mix – often because the quality of data may not be there. In fact, an accusation often levied against ESG screening and ESG data in general is that it is biased against large cap companies – which Bai says are often the worst offenders - and leaves out portions of the market, especially emerging markets.

“For instance, what factors are rewarded by the market? Governance might be, but environmental and social parameters might not. I think the point is that as active managers, we cannot blindly apply the same rationales that we use for developed markets to emerging markets,” said Jeremy Peng, VP of investments and portfolio manager at NEI investments, speaking at the executive forum.

So Bai takes an alternative route. He taps into unconventional data points that far better address the complexity and subjectivity of ESG investing and are far more regular than standard emerging market disclosures.

Alternative data in China for example, can comprise search engine data, job postings and satellite snapshots. And it’s these leads – often more detailed and directly addressing ESG issues than any standard quarterly report may – that mesh well with a strategy focused on reliable and responsible growth.

Another source of important information in emerging markets is the exchanges themselves.

“It’s interesting to note that emerging markets exchanges have been leaders within the global Sustainable Stock Exchanges Initiative,” says Michelle de Cordova, Principal, ESG Global Advisors. “Emerging markets exchanges have been quick to identify better ESG practice and disclosure as a way to build local and international investor trust in their markets.”

High-impact engagement

If you’re an active investor and want to change corporate behaviour, “smaller, domestic emerging markets companies want to listen,” says Bai. With less competition it can be difficult to move giants and make meaningful changes.

“The variability of ESG practice and disclosure among emerging markets companies makes corporate engagement a potentially productive strategy,” says Cotte, “because shareholders can engage companies in discussions comparing their performance with those of emerging market peers.”

“For investors seeking to align with the Sustainable Development Goals, being invested in emerging markets and then using investor status to engage companies to improve ESG and sustainability performance can be a direct and effective way to create impact,” adds de Cordova.

Bai agrees, noting that smaller emerging market companies might not yet be fully versed in ESG expectations and they’re keen to hear about what will help them succeed.  Sitting down with management can lead to “high impact opportunities,” and a way to secure and grow that alpha in emerging markets.

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