Sustainable investing can be a win-win solution for investors in emerging markets. It can have an impact, playing an important role in allocating capital to tackle climate change and other sustainability issues. It can also improve risk-adjusted returns by integrating environmental, social, and corporate governance metrics and assessments to better understand risks and opportunities. This is particularly important in emerging markets, where many companies are exposed to higher levels of ESG risks that can become financially material. Those who don’t use ESG in emerging market investing aren’t using all the tools available to help them understand a complex and risky set of investments.
Let’s take the ROI part first. Emerging market funds that focus on sustainability have generated slightly better returns, on average, than their traditional counterparts. For equity funds, those in Morningstar’s Global Emerging Markets Equity category that are also classified as sustainable investments have an average category ranking of 46 out of 100 for the three- and five-year periods (through June 30 ). Year-to-date, the average ranking of emerging markets sustainable equity funds is 50. A major index of sustainability leaders, the MSCI Emerging Markets ESG Leaders Index, has outperformed the MSCI Index Emerging Markets over the three, five and ten year periods ended. June 2022. The ESG index also has a beta of 0.95 against the broad index, an indicator of lower risk.
On the fixed income side, funds in the Morningstar Global Emerging Markets Fixed Income category that are also classified as sustainable investments have an average category ranking of 41 out of 100 for the year to date, 41 for the last three years, and 42 for the last five years.
While these results do not mean that sustainable emerging market funds will always outperform the broader universe, they do support the idea that taking ESG into account can improve returns. Active managers say ESG assessments can help identify the best companies in emerging markets. An RBC report, for example, notes that companies that are already paying attention to ESG issues tend to have a more engaged and productive workforce and good relationships with their stakeholders, making them “more likely to succeed financially.
A report by William Blair agrees, adding that an ESG focus can help identify emerging market companies with better governance and corporate culture, while noting that “a variety of environmental and social issues have become increasingly relevant to investors” and stakeholders. Customers and employees in emerging markets demand that companies set higher standards, just as they do in developed markets.
Sustainable investing in emerging markets can also have a significant impact. It can move much-needed capital to tackle climate change and other sustainability issues. The Paris Agreement and the United Nations Sustainable Development Goals require that significant capital be directed to emerging markets, but there is currently a huge financing gap. Investors can help bridge the gap by making sustainable investments in emerging markets. Through instruments such as green bonds, investors can help finance critical infrastructure needs, energy transition and renewable energy projects. Equity investors can help emerging market companies along their sustainability journey. More and more companies in emerging markets understand the need to tackle negative externalities, create better working conditions and act ethically. These actions enhance their reputation with customers as well as investors. Through direct engagement with companies, sustainable funds and the asset managers who run them can provide critical advice and guidance. A commitment to net zero carbon emissions and addressing other sustainability issues is a good way for an emerging market company to attract foreign capital.
Certainly, holdings in sustainable portfolios from emerging markets may face more ESG-related risks than those in sustainable portfolios that focus on developed markets, including high-visibility controversies, such as product spills. poisons, human rights abuses and corruption. Many emerging market companies have focused less on sustainability and stakeholder value than their developed market counterparts. But their need for foreign capital and the willingness of sustainable investors to engage with emerging market companies on climate change and other sustainability issues will help them improve in these areas. Sustainable investors should view their allocations to emerging markets not as problematic, but as opportunities for both competitive investments and impactful results.