Why ESG Investing Helps With Emerging Market Picks

Debbie Carlson

Using environmental, social and governance criteria, known as ESG, may help investors pick high-quality emerging-market stocks and funds for their portfolio.

Most socially responsible investing is centered in developed markets where more data and metrics are available. Research shows that these types of responsible investments in developed markets don't suffer from performance drag by shunning certain investments or sectors, and often can outperform over the long run because focusing on diversity, sustainability and ethical governance pay its own dividends.

Now there is some evidence these criteria can be applied to emerging markets with positive results, as adding ESG analysis gives investors more information about an area where market transparency can be limited and there is less research coverage.

"[It's] really not just about people feeling good about their investments, but it's really about applying another lens into investing that might illuminate some issues that investors have not had access to," said Sarah Kjellberg, head of sustainable exchange-traded funds at BlackRock.

One ESG fund example is BlackRocks' iShares ESG MSCI EM ETF (ticker: ESGE).

But like any investment, people need to be diligent. There are no standards on what defines ESG, so investors should read a fund's prospectus carefully to understand the manager's philosophy or index's strategy to ensure it focuses on criteria they consider important. Other factors like political turmoil or economic cycles can mute a so-called responsible investment's influence, which is why ESG managers focus on long-term returns.

Here are a few things to consider with this type of investing:

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-- Research suggests that ESG adds value.

-- The importance of good governance.

-- Emerging markets' advantages.

Research Suggests ESG Adds Value

In a research report from November 2016, Cambridge Associates examined data for then relatively new MSCI Emerging Markets ESG Index and determined for the first three years of the index's existence, there was "early but consistent evidence that ESG--based stock selection can add value after accounting for the impact of other factors such as style, country and sector exposure. Analysis of available ESG data for the preceding six and half years broadly indicates the same."

When looking at ESG in emerging markets, the report said it's prudent to review how the manager incorporates ESG factors, for what reason and how consistently and whether ESG-based stock selection has added value to their funds.

Although the research report didn't break out the impact of the three environmental, social and governance factors, it did state "we would hypothesize that governance quality, which is highly variable in emerging markets, is a key factor."

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The Importance of Good Governance

Jeff Finkelman, a senior research associate for impact investments at Athena Capital Advisors, says there is some overlap between ESG and what regular investors call quality, which considers good corporate governance, a management team that takes a long-term view and doesn't go deep into debt.

Good governance is important in developed markets, but he says it's even more important in emerging markets.

"If you don't take that approach, you risk holding companies where you could do much worse," he says.

When ESG fund managers meet with companies they seek to invest in, they want to know not only how the firm views shareholders, but also how it treats its employees, stewards the business and the firm's interaction with the community and country such as paying taxes. This can give ESG investment managers insights beyond short-term results, says Gary Greenberg, head of global emerging markets at Hermes Investment Management who manages Calvert's Emerging Markets Equity Fund ( CVMIX).

An example of poor business stewardship is Brazilian miner Vale, he says. The January collapse of a dam at one of Vale's properties killed more than 200 people and is considered Brazil's worst industrial accident. News reports say the company knew the dam was a problem, and this month a Brazilian judge ordered Vale S.A. ( VALE) to pay all compensation for damages related to the break.

Signs such as management not paying attention to safety issues is one way to use ESG criteria to avoid a bad investment, Greenberg says.

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When it comes to governance, many ESG funds may limit exposure to state-owned enterprises. These entities participate in commercial activities on behalf of the government and are prevalent in emerging markets. Well-known companies include Brazil's Petrobras ( PBR), which has a mix of state and public shares.

Gaurav Sinha, an asset allocation strategist at ETF provider WisdomTree, says state-owned enterprises often have poor governance because of divided loyalties -- what the government wants can be at odds with other shareholder voices. He says research by WisdomTree reviewing returns from 2007 to 2018 shows the standard annual returns of an index of nonstate-owned enterprises versus state-owned enterprises was 10.3% versus 6.7%.

Emerging Markets' Advantages

Greenberg says while governance is a big focus now for emerging markets ESG, he sees environmental and social issues becoming more important -- especially as these regions may be subject to greater risks from climate change.

Technological breakthroughs may give emerging markets an advantage over developed markets, says Julie Gorte, senior vice president for sustainable investing at Pax World Funds.

Two examples are telephony and electric vehicles. For telephony, although emerging markets still must build infrastructure for cell towers, they don't have to worry about paying to support landlines that developed markets do.

The same goes for electric vehicles -- emerging markets can build new factories designed for these vehicles; North America and European manufacturers have to retrofit old internal-combustion engine factories to build electric vehicles. That efficiency can boost returns.

When applying ESG criteria and thinking of investments, people need to consider the role of a company's product play, she says, which can differ between markets.

And ESG investments may not be immediately obvious to developed-world investors. Sudhir Roc-Sennett, head of thought leadership and ESG at Vontobel Asset Management, whose firm has invested in emerging markets for 20 years, says one of their holdings, Indian financial service company, HDFC Holding, is an example of how they view ESG. HDFC brings advanced technology and banking services to previously nonbanking areas, which is both an economic and social good and boosts India's economic growth.

ESG investing in emerging markets is still in its infancy, as is investing in these regions. But Kjellberg says the trend of companies and countries only being concerned with growth-at-any costs may be changing.

"We're seeing countries like China and others starting to require companies to be more aware of things like product safety," she says. "Consumers are voting with their dollars and they're saying sustainability issues are important."

Debbie Carlson has more than 20 years experience as a journalist and has had bylines in Barron's, The Wall Street Journal, the Chicago Tribune, The Guardian, and other publications. Follow her on Twitter at @debbiecarlson1.