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yourSRI: Developing versus Emerging Markets
Topic of the month February 2019
Interestingly, an overwhelming conclusion from many of the ESG studies was that the impact of ESG investment approaches was not globally uniform. Most notably, ESG strategies had significantly greater impact in Emerging Market (EM) stocks than in Developed Markets (DM). This suggests that ESG investment is most effective where there is greatest divergence in ESG performance (where there is greatest need to filter out the worst-prepared companies) and where the wider institutional, regulatory and economic environments are weakest (i.e., operational risks are more pronounced).
The Friede (2015) meta study found the strongest ESGCFP correlation in EM (65 percent positive compared to 38 percent positive for DM as a whole).¹
Cambridge Associates (2016) findings were even more stark, finding that integrating ESG factors into stock selection processes added significant value in EM equities but had little effect on DM equities. They found that the MSCI ESG EM Index consistently outperformed its parent MSCI EM index by a cumulative 12 percent (2013 – 2016)² while the MSCI World ESG Index statistically shows barely any divergence from its parent MSCI World Index and even slightly underperformed.
This suggests that ESG’s role in reducing tail-risks and stock volatility has a greater impact in EM compared to DM. Risklab found that “tail risk” (the risk of unlikely events causing catastrophic damage) can be reduced by nearly 40 percent in an EM portfolio that has limited its exposure to ESG risks.” Political and social instability poses greater exposure to tail risks. Sustainalytics (2012) found that EM companies have a higher frequency of the most severe ESG controversies, particularly societal and community-related incidents.
Various studies (MSCI 2018a, Deutsche Bank 2018 and Cambridge Associates 2016) have found that the main driver of outperformance in the ESG funds was careful stock selection: in EM “54 percent of the ESG index’s excess return over its parent was attributable to stock-specific sources” (Cambridge Associates 2016). This factor outweighed inherent ESG tilts towards factors such as sector, size, geography and quality. In short, in markets where the wider operational context provides more instability, the portfolio manager’s ability to employ ESG considerations in stock selection adds significant value.
We should note that these findings did not rule out ESG’s value in DM, while it is a less overt tool for finding alpha in DM, its sophisticated use “provides another key tool for thoughtful managers in this space to make individual judgments of materiality” (Cambridge Associates 2016).
Why ESG investment approaches have the most impact in EM
Naturally, this leads us to question why this pattern is emerging and what it means for asset managers.
“Lottery of birth” – context matters
MSCI (2018a) found that countries which score well on factors such as governance of institutions, human capital productivity and natural resource management, deliver conducive environments for good business. Companies in these markets were typically less exposed and better positioned to manage significant ESG risks than global peers. Conversely, there is a clear ”market drag” – “as the sovereign ESG ratings declined, the ESG ratings of companies domiciled in these countries tended to fall below global industry peers, primarily due to their elevated risk profiles”.
Other systemic business factors in Emerging Markets
Many of the business norms and practices which have been associated with better corporate management and performance are not prevalent in EM.
One of the major critiques is weaker levels of disclosure – EM companies tend to be less transparent about their business policies and procedures to manage major risks and there is poorer data on performance indicators such as environmental impacts, safety records, and other human capital metrics. This information blind spot is exacerbated by weaker interrogation of corporate controversies by the press and civil society. This can make it harder to evaluate EM companies. More significantly, by facing less scrutiny to meet and disclose on global operational norms EM companies might be underprepared to meet operational and business risks.
Governance factors are commonly raised as the major differentiator between EM and DM companies. In EM, state-owned enterprises and family-controlled firms are more prevalent, these ownership structures are often associated with market underperformance. A key area of concern is the rights and protections for minority shareholders (in relation to the heightened risks posed in controlled companies of prioritizing political, social or private ends over shareholder value). In addition, corporate governance regulation, oversight, and enforcement, that support better management, are typically laxer than for Western peers. Sustainalytics (2012) reports the biggest performance gaps between EM companies and their DM peers are in governance and anti-corruption standards.
However, corporate governance (CG) norms and regulations are improving in EM, Farient Advisors (2018) observe increasing focus on this in Saudi Arabia, China, Singapore, Brazil, and India but at an uneven pace. Many EM countries have recently adopted or revised their company and security codes and laws.³ Nevertheless, on many metrics, CG standards are still lower in EM and momentum to raise the bar still lags DM. Farient Advisors opine that while there is an “unmistakable and growing convergence in key governance practices – certain variations, driven by cultural differences, will persist.”
Asset managers using ESG to identify outperformance
In this context it becomes clear that ESG becomes a valuable tool-set for skilled asset managers to identify EM outperformers in these growth markets while controlling downside tail risks.⁴
“The positive results of ESG-based stock selection highlight how important evaluating ESG quality of companies could be to active management in emerging markets. We observed huge variations in the depth of application and, as ever, manager selection is critical.”
Cambridge Associates (2016)
The sophisticated ESG investor operating in EM adds value by understanding that Western standards are not always fully applicable in EM. Deeper analysis of the board’s practices is needed where governance structures can seem on-the-face-of-it unattractive. As minority shareholders rights are less protected, it is advisable to focus on the board’s track record vis-à-vis the long-term interests of minority shareholders. To overcome the information gaps, it is important to undertake more proprietary research and engage directly with companies.
CG is not the only area of risk exposure. MSCI (2017a) estimates that “on average, 16 percent of MSCI Emerging Market Index constituents’ operations were located in regions characterized by especially fragile ecosystems, and 24 percent of operations were located in regions with the highest corruption perception levels.” Political, social, and environmental vulnerabilities raise particular risks according to industry sector and geography; it is therefore vital to keep up-to-date with country and industry trends. For example, water stress is highly acute in Chile and this has particular management implications for utility & mining companies. Fragile ecosystems (e.g. Brazil, Indonesia) and high prevalence of natural disasters (e.g. India) have implications for many resource industries as well as insurance companies. Workplace safety standards and labor rights are an acute issue in many EM and Asian countries, requiring deeper investigations into operating standards and supply chain oversight.⁵ For example, an emerging hot topic for IT hardware companies is greater due diligence of their cobalt supply chains, where human rights abuses are severe. Sustainalytics (2017b) observes that Kenya, South Africa, Malaysia, and Chile stand out as particularly risky markets, as more incidents occur in these countries than might be expected given their size but India is the top EM culprit for ESG incidents.
1) Interestingly, they also found the correlations were stable over time, despite expectations that ESG alpha would have shrinking correlations over time due to learning effects in capital markets.
2) This short period being from the launch of the MSCI ESG EM Index in June 2013 to June 2016
3) This includes: China, Hong Kong, Japan, Korea, India, Mexico, Singapore and Saudi Arabia (OECD 2017)
4) MSCI (Jan 2018) found that there is a narrow quadrant of only 15 percent of EM companies in the MSCI global index that met both the 50% threshold on global governance standards AND exceeded their own country’s ESG sovereign rating. In this context, careful stock selection based on deep understanding of local markets clearly becomes more vital.
5) MSCI 2017a reports that “China has seen a series of industrial accidents leading to 66,000 workplace deaths and around 282,000 workplace accidents in 2015. With around 6 occupational fatalities per USD billion GDP, the workplace fatality rate in China is more than twenty times that of other major global economies. The large disparity can be attributed to a lax regulatory environment and uneven enforcement surrounding workplace safety.”