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Sustainable investing can be a win-win for emerging-markets investors. For one, it can be impactful, playing an important role in allocating capital to address climate change and other sustainability issues, but it can also improve risk-adjusted returns by incorporating environmental, social, and corporate governance (ESG) metrics and evaluations to better understand risks and opportunities.
This is especially important in emerging markets, where many companies are exposed to higher levels of ESG risks that can become financially material. Those not using ESG in emerging markets investing are not using all the available tools to help them understand a complex and risky set of investments.
Attracting Foreign Capital
Let's take the investment returns part first. Emerging markets funds that have a sustainability emphasis have delivered slightly better returns, on average, than their traditional counterparts.
For equity funds, those in the Morningstar's Global Emerging Markets Equity Category that are also classified as Sustainable Investments, have an average category rank of 50 out of 100 for the year to date (through June 30).
For the three- and five-year trailing periods, sustainable emerging markets equity funds' average rank is 46. A prominent index of sustainability leaders, the MSCI Emerging Markets ESG Leaders Index has outperformed the MSCI Emerging Markets Index over three, five, and 10 years ending June 2022. The ESG index also has a beta of 0.95 versus the broad index, an indicator of lower risk.
On the fixed income side, funds in the Morningstar Emerging Markets Fixed Income global category that are also classified as sustainable investments have an average category rank of 41 out of 100 for the year to date, 41 for the trailing three years and 42 for the trailing five years.
While these results don't mean sustainable emerging-markets funds will always outperform the broader universe, they do support the idea that taking ESG into consideration can enhance returns.
Active managers say ESG evaluations can help identify better emerging markets companies. An RBC report, for example, notes companies already paying attention to ESG issues tend to have more engaged and productive workforces and good relations with their stakeholders, making them "more likely to be successful financially."
A William Blair report concurs, adding that an ESG focus can help identify emerging markets firms with better governance and business culture, noting that "a variety of environmental and social issues have become increasingly relevant to investors" and stakeholders. Customers and employees in emerging markets are demanding that companies set higher standards just as they are in developed markets.
Sustainable investing in emerging markets can also have significant impact. It can move much-needed capital to address climate change and other sustainability issues. The Paris Agreement and the United Nations’ Sustainable Development Goals require significant capital be directed toward emerging markets, but there is currently a massive funding gap. Investors can help close that gap by making sustainable investments in emerging markets.
Through instruments like green bonds, they can also help finance critical infrastructure needs, the energy transition, and renewable energy projects. Equity investors can help emerging markets companies along their sustainability journeys. More emerging-markets companies understand the need to address negative externalities, create better working conditions, and operate ethically. These actions burnish their reputations with customers as well as investors.
Through direct engagement with companies, sustainable funds and the asset managers that run them can provide critical advice and guidance. A commitment to net zero carbon emissions and to address other sustainability issues is a good way for an emerging-markets company to attract foreign capital.
Competetive and Impactful
To be sure, holdings in sustainable emerging-markets portfolios may face more ESG-related risks than those in sustainable portfolios that focus on developed markets, including high-visibility controversies, such as toxic spills, human-rights violations, and corruption. Many emerging-markets companies have been less focused on sustainability and stakeholder value than their developed-markets counterparts.
But their need for foreign capital, and the willingness of sustainable investors to engage with emerging markets companies on climate change and other sustainability issues will help them improve in these areas. Sustainable investors should consider their emerging-markets allocations, not as problematic, but as opportunities for both competitive investment and impactful outcomes.
John Hale is global head of sustainability research at Morningstar
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