Investors considering impact, sustainable and socially responsible investment (SRI) themes do not need to confine their searches to U.S. assets. As the universe of environmental, social and governance (ESG) products expands, so does the opportunity for investors to apply ESG principles to international investments, including emerging markets.
In some ways, developing economies make for ideal avenues for ESG investments, including exchange traded funds (ETFs). Many emerging markets do not yet have the environmental standards their developed counterparts have. For example, China is the world's largest polluter. When it comes to the S in ESG, some developing countries have dubious human rights records. Likewise, there is room for improvement on the governance front as some of the largest emerging markets companies are state-owned and/or lack diversity on their boards and in the C-suite.
Those factors and others indicate that some emerging markets companies lag behind their developed world counterparts when it comes to ESG principles. On the other hand, that room for improvement and increased prioritization of ESG virtues in the emerging world could spell opportunity with dedicated emerging markets ESG products going forward.
Assessing the Opportunities
Some studies suggest ESG is a viable investment methodologies in emerging markets.
“Investing in emerging markets can carry a high degree of risk, not least from the threat of environmental, social and political instability,” said index provider MSCI. “Research suggests that 'tail risk' - the risk of unlikely events causing catastrophic damage - may be reduced in an emerging markets portfolio that has limited its exposure to these ESG risks. Emerging market asset managers keen to utilize ESG analysis have historically faced significant information problems; however, with the introduction of stewardship codes in the Asia Pacific region and an emphasis on reporting and disclosure globally, this is changing.”
The iShares MSCI EM ESG Optimized ETF (ESGE) is one member of the emerging markets ESG ETF club. ESGE is a year and a half year old and has about $150 million in assets under management, making it one of the more successful US-listed ESG ETFs.
The ETF tracks the MSCI Emerging Markets ESG Focus Index and holds 240 stocks, significantly fewer than are found in the MSCI Emerging Markets Index.
“Tobacco and Controversial Weapons companies are excluded from the index. Securities of companies involved in very severe business controversies are not eligible for inclusion,” according to MSCI. “Other exclusions include where companies do not have the controversy score or IVA rating or ESG score. Constituents are selected to maximize exposure to higher ESG IVA scores, subject to maintaining risk and return characteristics similar to the parent index.”
A new entrant to the emerging markets ESG ETF fray is the Nushares ESG Emerging Markets Equity ETF (NUEM), which debuted in June. Like the aforementioned ESGE, NUEM is heavily allocated to China, South Korea and Taiwan.
NUEM's underlying index, the TIAA ESG Emerging Markets Equity Index, “uses a rules-based methodology to arrive at a diversified portfolio of equity securities issued by companies located in countries with emerging markets that adhere to predetermined ESG, controversial business involvement and low-carbon criteria,” according to Nushares.
Waiting On Performance
Emerging markets ESG funds are still new compared to other ESG products. Additionally, there are other factors investors need to consider before betting on significant out-performance with emerging markets ESG ETFs.
“It's been the MSCI Emerging Markets tracking funds, because if you take a look at some of the other overweights, for example, South Africa was overweight, South Africa specifically does better in ESG risks, that currency has depreciated by 20% to 30% during the past three years because of the commodity crisis,” said Morningstar. “Meanwhile, the Chinese currency has soft pegged to the dollar, so it follows the exchange rate fluctuations along with the dollar. So, it hasn't been as affected by a rising dollar.”
Still, some studies prove sustainable investing in emerging markets is viable. A report by NN Investment Partners and the European Centre for Corporate Engagement (ECCE) at Maastricht University, “‘The Materiality of ESG factors for emerging markets equity investment decisions: academic evidence,” shows “gains from investing in companies with higher ESG ratings are stronger in EMs than in Developed Markets while ownership structures of companies is the most important corporate governance driver,” according to NN Investment Partners.