How does sustainable investing work in emerging markets, where corruption is often rampant, corporate disclosures are rare, and the air in cities like Delhi or Jinan in eastern China can be suffocating—and that’s before considering problems like child labor or illiteracy? It’s the question a skeptical global fund manager asked me after yet another fund-industry conference teeming with enthusiastic calls for investing that takes environmental, social, and governance, or ESG, factors into account.
It’s true that emerging markets are more vulnerable to ESG-related issues, such as extreme weather, like droughts and floods; social unrest; and heavy political involvement with private companies. But the ideas aren’t incongruous. In fact, using ESG factors when investing in emerging markets, rather than being counterintuitive, can lead to more significant outperformance, according to several veteran emerging markets managers. Mark Mobius, who retired from Franklin Templeton Investments in January and just launched a new firm to focus on ESG investing, has cited corruption as one of the things that can derail investors. His former colleague Michael Hasenstab, Templeton’s global bond guru, argues governance is key to economic growth and resiliency. The folks at GMO agree, adding that it’s of the “utmost importance” that stockpickers factor in country-level and company-level ESG risks. GMO also argues that ESG signals are especially useful for concentrated stockpickers who tend to pay up for quality growth companies, since a problem could be especially expensive.
Indeed, the MSCI EM ESG Leaders index has beaten the MSCI Emerging Markets index by 1.7 percentage points annually over the past three years.
Emerging market fund managers have long focused on governance, since rule of law and disclosures can be shaky in the countries they invest in. The “E” in ESG is becoming easier to address, as governments in developing countries focus more on environmental factors, grapple with pollution, and jockey for a global competitive advantage. That’s the case with China, which Matthews Asia ESG fund manager Vivek Tanneeru recently described in a note as likely to become the “de facto” leader in addressing climate change and in renewable energy.
Social issues, like gender equality, are trickier, especially because of cultural differences. But investors in global companies are increasingly scrutinizing supply chains—essentially, which other companies the bigger ones do business with to source and produce whatever is needed to create their final products—and that is bringing attention to child labor and working conditions in emerging markets. Granted, emerging market countries and companies are probably least forthcoming with disclosures and data in this area, but that is improving.
About 40% of sustainable reporting overall comes from emerging market companies, according to Sustainalytics. MSCI says it has seen a surge in interest from Chinese companies wanting to learn more about ESG.
What’s more, several emerging markets beat the U.S. in Morningstar’s sustainable ratings. South Africa, Brazil, and Turkey all rank higher than the U.S. in terms of sustainability—and that is not because they’re being graded on a curve. The rankings don’t take a top-down macro view; they compare each company to their global peers in their industry. So Naspers (ticker: NPN.South Africa), best known for its stake in internet companies like Tencent Holdings (700.Hong Kong), makes up about a quarter of South Africa’s index, boosting the country’s overall score. ESG-related controversies in big companies like Wells Fargo(WFC) and Facebook (FB) hold the U.S. back, says Dan Lefkovitz, a strategist at Morningstar Indexes.