This article argues that environmental, social and governance-based ideas can help identify potential sources of alpha in emerging market companies

The following commentary comes from Aviva Investors. This publication is pleased to share these views, but stresses that comments from outside contributors are not necessarily shared by this news service. Email the editors at tom.burroughes@wealthbriefing.com and jackie.bennion@clearviewpublishing.com

Emerging markets have become the world’s most dynamic growth engines in recent decades, giving rise to an impressive host of new companies, technological innovations and consumer trends.

Nowhere is the importance of these markets and their growth reflected more clearly than in financial markets, with the MSCI Emerging Markets Index seeing an annualised return of 8.68 per cent in US-dollar terms between its launch on 1 January 2001 and 31 May 2019. The opportunity set in emerging market debt is also growing, with the tradable asset class now amounting to $25 trillion, a 16 per cent rise every year since 2000.  

It is little surprise that investors have sought to tap this growth by shifting from a tactical to a more strategic investment approach towards emerging markets. Rapid economic development, however, does not come without its challenges. With recent high-profile sovereign and corporate events in emerging markets, investors’ risk analysis and investment processes need to move beyond the traditional fundamental variables to also incorporate considerations of emerging markets’ environmental, social and governance (ESG) issues.

A lesson from Argentina
Emerging market debt investors have historically focused on fundamental variables, such as the growth outlook, debt metrics and external sources of finance when analysing, for instance, the credit spread of sovereign bonds. However, one only needs to look at the recent events in Argentina to understand why ESG factors play an important role in determining risk-adjusted returns.

Following a heavy defeat in August for incumbent pro-business President Mauricio Macri to the opposition populist Peronist candidate Alberto Fernández in a nationwide primary election, the country’s prospects have become more uncertain, with both the peso and stocks seeing significant drops and several of the country’s US-dollar denominated bonds experiencing spikes in yield.

Considering the economic difficulties Argentinians have been facing and the previous governance track record of Peronist administrations, this highlights the importance of supplementing traditional indicators with ESG analysis to fully assess risks and opportunities.  

Behind the numbers
It is increasingly recognised that ESG analysis can help identify potential sources of alpha in emerging market companies. One such source is the drag on returns that emerging market state-owned companies (SOEs), which often have poor ESG scores, can have. Governance issues at these firms, for example, have at their worse plunged a number of them into scandal, such as Brazilian energy giant Petrobras, in which the government directly or indirectly has 64 per cent of the voting shares.

Reducing exposure to such firms can lift returns. A study by Cambridge Associates found that, due to low ESG scores, the MSCI EM ESG Leaders Index only had exposure to two of the only 13 SOEs listed in the MSCI EM ESG Index’s top 40 companies. Interestingly, not holding these remaining 11 stocks contributed positively to outperformance. In the 10-year period ending 31 May, the index gained 9.12 per cent compared with the broader MSCI EM Index, which saw a 5.38 per cent increase. In this respect, ESG considerations are able to identify and exclude underperforming companies to generate alpha.

Avoiding scandal, uncovering hidden gems
In today’s markets, companies are punished heavily for corporate governance failures, making ESG considerations crucial for avoiding stock-specific risk events in emerging markets. Such analysis for example can also help investors uncover hidden gems within emerging markets, such as Malaysian nitrile gloves manufacturer Hartalega Holdings, which has outpaced its competitors both in ESG practices and profitability.

Companies like Hartalega understand that the rising influence of international shareholders and the ability to tap into international capital markets means that they will come under increasing scrutiny for their ESG standards.

Rather than seeing this as a negative, a lot of companies are beginning to understand how incorporating ESG values can give them a competitive advantage. Hartalega, for example, has been able to use its facilities, which meet or exceed environmental standards, to secure most of its revenues from the US and Europe, where environmental regulations are stricter.

Further to that, its health, safety and environmental performance regularly outpaces peers, avoiding the risk of scandal that would put investors off. Such tangible metrics also help investors avoid "greenwashing", where companies make unsubstantiated ESG claims.

Change on the horizon
As emerging markets develop, investors may see an increasing pool of opportunities as companies are forced to conform to governance reforms. For instance, the Malaysian Prime Minister, Mahathir Mohamad, has promised an ambitious programme of corporate reform to encourage institutional independence and accountability following the 1MBD scandal. Changing attitudes abroad may also force emerging market companies to change in order to tap into global supply chains. Companies will need to step up their environmental and labour standards in order to meet international regulations.

Investors must go beyond traditional metrics. A measurement of ESG is not merely that it is a nice investment to have but it can be an important differentiator - one that helps investors avoid companies at risk of falling victim to scandal, while also helping them uncover outperforming companies that strive to meet the highest standards.