The fundamentals driving emerging market stocks are attractive in an uncertain world, but does ESG risk come with the territory?
In 2018, Donald Trump declared war on China. This was different from most conflicts in that not a single bullet was fired. Instead trade tariffs were implemented. This was an economic war which was, among other things, declared to stop cheap imports flooding into the United States.
Such action by the leader of the world’s largest economy shows how far emerging markets have come as an economic powerhouse. A large, youthful workforce, a growing middle class and high economic growth are the fundamentals that make emerging markets an attractive hunting ground for investors.
Indeed, emerging market stocks have been used as a diversifier by some, while others just want exposure to the huge growth forecasts attached to some of these regions. These growth projections have been revised to reflect current events, but the fundamentals are likely to put these markets back onto their growth trajectory. This could be especially true for well-managed businesses in wealthy Asian economies, including South Korea, Taiwan and China.
Yet regulation across the developing world has been criticised for not being stringent enough, while the standard of corporate disclosures needs to be improved.
This last point makes ESG more important in emerging markets. Due to the information environment typically being weaker it creates more of an opportunity for ESG to lead the insight in company selection.
“Emerging market companies can profit from managing ESG issues well, especially where governance is concerned,” says Marta Jankovic, director, EMEA head of iShares sustainable at BlackRock.
The question is, while many developed world investors will agree with Jankovic, are emerging market governments and regulators ensuring that ESG risks are being suitably managed? And, do executives in these regions understand the impact a robust ESG policy can have on their business?
Getting the message
Research highlighting the benefits of implementing sustainable business practices is feeding through to developing nation companies, says Kathryn Langridge, senior portfolio manager and head of emerging market equities at Manulife Investment Management. “Across emerging markets there is an increasing realisation of the importance of not just engaging with investors but incorporating ESG risk management into their businesses,” she adds.
Langridge is seeing some emerging market companies spend years improving their management of such exposures, but she is also seeing companies who just “do not get it”.
More and more emerging market companies and governments are getting it, yet ESG is still less established than it is inEurope as an investment concept but is catching up fast, says Fabiana Fedeli, global head of fundamental equities at Robeco and a portfolio manager in the firm’s emerging market equity team. There are large differences in the level of awareness from country to country.
Awareness is growing faster in some places than others. China is a country that has warmed to managing ESG risk in recent years. Brazil is another convert thanks to a series of environmental and governance disasters. “The environment is at the forefront of many companies’ plans and strategies, but we are not where we should be,” Fedeli says. “There are still local governments and companies in developing countries who are not used to requests for information or strong scrutiny from investors.”
But are investors underestimating the pace of change? The results of company engagements conducted by Newton Investment Management have sometimes surprised Ian Burger, Newton’s head of responsible investment. “Companies are managing ESG risk, but they are not telling their stories and some of them have great stories to tell,” Burger says. “This is frustrating, but it also adds an element of opportunity.”
Emerging markets do not have a monopoly on poor standards of governance.Kathryn Langridge, Manulife Investment Management
New thinking, especially on the environment, could be driven by changing public attitudes. Gabriel Wilson-Otto, BNP Paribas Asset Management’s head of stewardship in Asia Pacific, believes so. “I have seen studies and surveys that point towards increasing discomfort around air pollution,” he says. “There has been a push in mainland China against the air pollution levels in many cities.”
An APEC event in Beijing a few years ago highlighted the issue. The government halted industrial production to ensure there were blue skies above the city for the conference. “APEC Blue became a phrase for something wonderful but fleeting and raised the profile of the push against air pollution,” Wilson-Otto says. “In my opinion, the people are increasingly influencing environmental policy decisions around the region.”
It is not just public opinion that is swaying policymakers. The falling cost of renewable forms of energy, such as wind and solar, is also influencing change. “Historically, due to the cost of renewables, the world had never been able to de-couple GDP growth and carbon emissions,” Wilson-Otto says. “As renewables become more cost competitive with coal the conversation is shifting.”
Protecting the environment has not just been an issue of cost. Weak policy and regulation have played a role as has a lack of awareness. China is an example of one government that has realised it needs to change, especially given that 1.4 billion people need freshwater to drink. It is spending billions of dollars on improving air quality and clearing pollution from its soil.
Not all developing nations are as wealthy as China and are not setting sustainable policies. Being responsible for feeding millions of people, supplying them energy and ensuring access to clean water and medical supplies could be why. They are dealing with today’s problems, not what are perceived to be the challenges of tomorrow.
Fedeli points to India, which is home to more than 1 billion people, as a country facing such a conflict. “Vast parts of its population do not have access to power, sanitation or clean water, so what do you think the priority is between using coal to generate power and not being able to provide power?” she says.
However, Fedeli believes that environmental concerns are pushing their way up the agenda with air quality in New Delhi causing increasing demand for healthcare.
ESG is more important for investors targeting emerging markets as the risks can be more acute. Many economies in these regions are weighted towards agriculture. There are also reports of human rights abuses through forced and child labour. Then there is the issue of population growth. While a growing younger demographic could be a benefit compared to the aging populations in the west, it can also be a curse.
Eric Nietsch, head of ESG in Asia at Manulife Investment Management, explains that Asia is home to substantial challenges. “There are probably more people in that region under environmental pressure than anywhere else in the world,” he adds. “It is home to almost two-thirds of the world’s population, which rely on a third of the world’s freshwater, and produces half of the globe’s greenhouse gas emissions.”
Of course, as emerging market companies expand, so will their influence. “As these companies grow their impact on the environment and society in Asia creates a strong case for ESG investing,” Nietsch says.
Companies are managing ESG risk, but they are not telling their stories and some of them have great stories to tell.Ian Burger, Newton Investment Management
But his colleague would like to remind investors that such risks are just as strong in the developed world. “Emerging markets do not have a monopoly on poor standards of governance,” Langridge says.
Wirecard, a German payments processor that went bust and is being investigated over alleged accounting malpractices, is an example. Yet despite this scandal, Langridge believes the conventional response when corporate governance issues come to the fore in emerging markets is still: “That’s what happens”. “Corporate governance failings may be no more common in emerging markets than in the developed world,” she adds.
The assumption that corporate governance risk is higher in the developing world is perhaps, Burger believes, due to a perceived lack of maturity. “Many companies in these regions were not trading 150 years ago,” he adds. “They have not evolved from family ownership to a public company with a widely distributed share register. As companies grow into that lifecycle, they start to mature.”
Knowledge is power
It is difficult to review ESG performance and assess risk without data and disclosures but getting hold of accurate information on developing nation corporates is reported to be low.
Yet Jankovic says that the quality and frequency of sustainable disclosures by emerging market companies is catching up with the levels experienced in developed markets. “Traditionally, company disclosure and availability of ESG data in emerging markets has been lagging behind developed markets, making it comparatively more difficult to analyse ESG performance,” she adds. “But this has improved in recent years. The data is getting more detailed.”
Robeco has proof that this is happening. For almost 20 years the asset manager has surveyed corporates in these regions and the level of responses it receives is rising. Indeed, RobecoSAM’s corporate sustainability assessment questioned 1,250 emerging market companies last year, up from “a small number” 10 years ago.
More companies willing to share data about their operations can only be good news. “We have more information than we had a few years ago, which allows us to take new approaches with the ESG analysis,” Nietsch says.
Information is also available from rating agencies. Yet some question the accuracy of their assessments believing that conclusions can vary. For example, an incident that happened at a company two or three years ago might be factored into one analyst’s view, but not another’s. “Under the hood, variations in timing of information could lead to different outcomes in relation to rating agency rankings,” Langridge says.
So, to understand the risks investors are taking they need to do their own on-the-ground research. This takes ESG integration beyond scores, disclosures and research notes, Mary-Therese Barton, head of emerging market debt at Pictet Asset Management, says.
“A score is only as good as the data coming into it and which is only as good as your interpretation of that score,” she adds. “To interpret that score properly you need to have a good understanding of the underlying issues. You cannot just buy these things off the shelf; it needs to be inherent in what you are doing.
“It is not enough to do standard country due diligence trips anymore,” Barton says. “You need to understand a country, top down, bottom up, and ESG is a core part of that.”
Emerging market companies can profit from managing ESG issues well, especially where governance is concerned.Marta Jankovic, BlackRock
Then there is the issue over the lack of a universal standard. “Even if they are disclosing on the same topic, they may use different metrics, frameworks and terminology in different parts of the world to communicate with investors,” Nietsch says. “That is why it is important to have good relationships with companies to make sense of the disclosures.”
This for Burger means having to show more commitment. “Ultimately, we need to undertake more due diligence,” he says. “It takes time to engage with companies, it is not as simple as just making a one-hour call.
“It cannot be outsourced,” he adds. “It needs to be done internally if you want to fully integrate it into your investment decisions.”
Doors appear to be opening when it comes to such enhanced due diligence. Fedeli says that 10 years ago there was little openness towards engagement from emerging market companies, but that has slowly changed as management and directors have become more aware of the power shareholders have.
As an example, she recalls meeting the finance director of an energy company in a developing nation which had received egative reports following an oil spill at one of its subsidiaries. This put the company on many investors’ exclusion lists, so it turned to Robeco for help to improve its ESG record. “Emerging market companies are coming to us as they are concerned about reputational risks,” Fedeli says. “That has been a game changer in the past couple of years.”
Another professional is also glad to see improvements in this area. “Looking at it from a macro angle, we are in the nascent stages of getting relevant data,” Barton says.
She recalls at the start of her career having to wade through large books to find macro-economic data, which is now available at her fingertips. “It is interesting seeing something similar with ESG data. We are only at the beginning.
“Given that we are in the early stages, you need to think outside the box in terms of how you conduct due diligence on a country,” Barton says. “It is not enough to do the usual meetings with business leaders, economists, political leaders and think tanks. You need to touch base with grass roots in terms of ESG factors.
“That requires a more nuanced approach and we have been building partnerships with organisations on the ground. You have to go where you have not gone before to understand the countries you invest in,” Barton says.
Jankovic shares her optimism that the level and quality of data will improve. “With tailwinds coming from investor demand and an evolution in the understanding of impact of sustainability risks for companies, we believe we will continue to see better data, which can only be, especially for emerging markets, a force for good.”
Who’s the boss?
Along with standards of risk management and the quality of data in emerging markets, investors need to aware of the high level of state and family ownership in these regions. Knowing who controls a company can be more important than profit forecasts or the strength of its balance sheet.
Understanding what the controlling shareholder’s motivations are and how they treat minority shareholders could be the difference between investing in a stock or walking away. This risk could be enhanced if the controlling shareholder is the government or a founding family. “Where a company is going to be first and foremost the instrument of the state, capital allocation decisions will clearly not prioritise minority shareholders,” Langridge says.
Ownership structures can also be a material consideration for Burger. “We often regard family-controlled companies as having a long-term alignment with our interests, which can give us comfort,” he says. “But we get nervous with state- ownership because of the potential lack of alignment between investors and the state’s political aspirations.
“Large sovereign ownership is not necessarily a red flag, but it is an issue we give appropriate consideration – we often avoid investing in companies where sovereigns are significant shareholders,” he adds.
Emerging market companies are coming to us as they are concerned about reputational risks. That has been a game changer in the past couple of years.Fabiana Fedeli, Robeco
Wilson-Otto admits that, in theory, there could be more risk when investing in a family or state-owned business but believes family businesses can also be aligned with building longer term value, which could match an investor’s objectives. The downside is that because it is a controlled entity, there is a risk of corporate governance issues or abuses of power.
“You get amazing examples, in developed markets as well as emerging, of family-owned companies that have shot the lights out, but you also see cases where there has been significant value destruction for minority shareholders,” Wilson-Otto says.
A different route
A few years ago, I hosted a roundtable to discuss equities with institutional investors and their asset managers. The head of investment for a local government pension scheme announced that he had sold some of the scheme’s passive investments to fund an active strategy, declaring: “If you want to be sustainable in emerging markets, you have to go active.”
The active fund manager sitting opposite him nodded in agreement, but this is not a universally held view. BlackRock’s Marta Jankovic is one such opposing voice. “We believe index investing enables investors to implement their sustainable preferences in an explicit and consistent way across different exposures,” she says.
“We hear people say index investing is not flexible enough for sustainable strategies, but that does not reflect the variety of ways investors use ETFs and index funds to take control of their investment outcomes,” she adds. “Index investors are active investors because they make active investment decisions. This extends to sustainable investing, where investors can use index investing to achieve a sustainable objective.”
Despite the pandemic, investor demand for index strategies, including emerging markets and global sustainability, is growing. Indeed, sustainable ETFs and index mutual funds had $220bn (£172.6bn) under management last year. According to Morningstar, index funds and ETFs represented 21% of European sustainable fund assets as at end of 2019. BlackRock anticipates that the level of assets in these vehicles could grow six-fold to $1.2trn (£941.7bn) within the next decade. ¹
Jankovic also points out that indexing is particularly valuable in the context of creating a common language for sustainable investing, underpinned by the transparency of rules-based ESG methodologies and product characteristics, adding that index approaches can deliver measurable, deliberate and predictable outcomes. Examples include improving ESG scores or reducing carbon emissions. ²
“The debate around active versus index investing does not consider that ESG indexing can drive better data disclosure,” she adds. “ESG data underpins all of our sustainable index products and we see companies are getting more savvy about the importance of sustainability-related disclosures and ESG ratings. This makes sustainable indexing an important way to deploy responsible capital at scale.”
Investors analysing data is typically followed by engagement, which is not a problem in the passive world. BlackRock has an active stewardship approach that seeks to drive long-term change within companies because the firm takes a patient capital perspective on the companies in its funds. “Our commitment can go beyond the tenure of the current board or management of a company and so we work to encourage practices that enhance sustainability and ultimately investment performance. ³
“Some voices in the market would question the impact index fund managers can have, given that they cannot sell their holdings. However, it is also because we cannot sell that we are so committed to stewardship activities.”
Engagement is not the only part of this. “Voting is part and parcel of stewardship and is a form of engagement mechanism for providing feedback to companies on investors’ perceptions of company performance,” Jankovic says.
BlackRock could vote against management teams that are not making progress on issues such as managing climate risk or adopting high standards of transparency, for example.
Awareness of ESG appears to be moving in the right direction. For Langridge, the trend is clear. “Over the past 20 years, there have been material improvements in corporate governance, transparency, engagement, openness and in understanding environmental and social risks.
“Companies are realising that they will attract a higher valuation and have better access to capital as a result,” she adds.
So the message is getting through to emerging market corporates and governments about the need to manage sustainability
risks thanks largely to pressure from international investors and, in places, the changing attitudes of its citizens and customers.
Burger summarises the main point that I have discovered in researching this article that when it comes to managing environmental, social and governance risk in the developing world: “Emerging-market companies are not all perfect, but neither are all developed-market companies.”
1) Projected growth. BlackRock projection, April 2020, based on
Morningstar data, as of March 2020.
Subject to change. The figures are for illustrative purposes only and there is no
guarantee the projections will come to pass.
2) Source: BlackRock as of July 17, 2020.
3)Source: BlackRock Investment Stewardship as of July 24, 2020.