Applied to emerging equities, environmental, social and governance criteria (ESG) are a key outperformance factor.
Emerging market companies proposing solutions to the environmental, social and governance challenges faced by their countries represent attractive investment opportunities, as their relative 10 year performances have demonstrated.
In terms of sustainability, emerging markets present a number of specific characteristics. They are on the front line in terms of climate risks and their energy in certain cases is likely to undergo significant change over the next 20 years. China for example, which depends mainly on coal, is the country which should have to increase its use of renewable energies the most by 2040.
The issue of governance is also one of the main challenges facing emerging markets. Standards in these countries tend to differ significantly from those in developed markets and also diverge widely between the different emerging markets. The average governance rating for emerging issuers stands at 4.95 compared to 5.88 among issuers from developed countries.
In a recent study carried out by our research teams, we sought to assess the impact of ESG selection on the performance of an emerging market equity portfolio. By comparing the result among the highest rated emerging issuers in terms of ESG criteria with the MSCI emerging markets index, the emerging issuers in question were 2.4% higher on average over the past 10 years. Furthermore, ESG portfolio volatility remained similar to traditional portfolios.
A performance gap in favour of sustainable leaders can be observed across all regions (Asia, Latin America and the Middle East & Africa) and across all markets caps. The gap is nonetheless wider among small & midcaps compared to large caps. This analysis also demonstrates that all sectors, apart from two, benefit from selecting issuers according to their ESG criteria. The energy sector is an interesting case in this regard. Although the 37 ESG securities returned a performance of 3.7% on average, underperforming the MSCI emerging equities index (4.2%), there was wide dispersion according to ESG score, with the highest ranked delivering average returns of 7.3%, while the lowest returned only a meagre 1.1%.
Other filters used to pick the most sustainable companies also have a particularly strong impact. This is the case with filters used to eliminate companies which are active in controversial sectors, such as munitions, gambling, alcohol and tobacco, or companies involved in major controversies. By excluding controversial companies from their emerging investment universe, investors can improve average returns by around 0.4%. By selecting investments through the use of normative filters, such as corruption risk, the respect of workers’ or human rights and environmental risk, excess performance is around 0.2%.
The study also led to the interesting observation that a downgrade in a company’s ESG rating may serve as a useful leading indicator to forecast relative performance over 6 months to 3 years. In general, a downgraded ESG rating rapidly leads to a sharp underperformance.
The analysis also demonstrated that integrating ESG criteria into emerging equities portfolio selection can produce value added over the long term, for a similar level of risk. In addition to selecting companies as a function of ESG criteria, the country in which they are domiciled must also nonetheless be taken into account, along with a consideration of where most of their production occurs and the main destination countries for their products and services. Our approach consists of evaluating countries as a function of their use of the 4 types of capital underpinning sustainable economic growth. The management of human capital, natural capital (renewable and non-renewable natural resources and environmental management), social capital and the sustainability of economic activity (to what extent is the current level of economic activity viable) also has a direct impact on the sustainability of the companies considered.
David CZUPRYNA - Head of ESG Client Portfolio Management