Despite concerns over the strength of the US dollar, domestic political uncertainty and fears of a US versus China trade war that have rattled emerging markets in 2018, Will Ballard, head of emerging market (EM) small-cap equities at Aviva Investors, discusses how Environmental, Social and Governance (ESG) integration can help reduce risk and extract outperformance within emerging market equities.
“The growing influence of emerging markets is commonly known. When comparing regions on a purchasing power parity basis, gross domestic product for emerging economies represents 59 per cent of the global total; a 23 percentage point increase over the past 30 years, according to the International Monetary Fund.1 The growing influence of EM is also reflected by relative investment performance over the long term. The annualised return of EM equities since the start of 2001 is about 9.26 per cent for the MSCI EM index, compared to 5.33 per cent for the MSCI World and 5.43 per cent for MSCI ACWI indices.
Not traditionally a first port of call for EM equities, ESG integration is an area in which active management can make a big difference by taking advantage of potential risk-return opportunities. The annualised return in the ten years ending 30 September 2018 was 9.07 per cent for the MSCI EM ESG Leaders index, compared to 5.4 per cent for the MSCI EM index during the same period.
ESG approach in EM equities is on different stages of the journey
“We are seeing steady progress, albeit with variations at the country, sector and company levels when it comes to adoption of ESG. In terms of governance, the rising influence of international shareholders is a key driver. EM companies wishing to tap into international capital markets are increasingly scrutinised for their governance standards, with many global investors placing more emphasis on activism and voting.
Environmental and social progress is subject to a wider variety of influences. In certain countries, for example China, a greater domestic focus on issues such as pollution is helping to push for reforms at the government and company levels. Global consumer and media scrutiny of companies’ supply chains are another significant driver of positive change; companies need to ensure their environmental and labour standards are uniformly high to be able to tap into the western consumer supply chain, particularly in sectors such as electronics and textiles.”
Protection in a riskier environment?
“The main drivers of EM share prices at the moment tend to be global macro factors, but to generate sustainably strong investment returns for clients over the medium term, investors need to be sure that they understand what the key company and industry-specific drivers are. ESG is an important part of that.
By monitoring and engaging with companies across a wide range of ESG indicators, we increase our confidence that they can thrive over the medium term. Of course, in a risky environment like we are currently experiencing, stock-specific risk events such as a corporate governance problem may be particularly punished by the markets, so ESG considerations become even more important. Companies that exhibit higher ESG improvements relative to their peers tend to be rewarded for their operational efficiency and higher resilience to certain risks, including labour, environmental and accounting problems.
For example, one of our holdings is in a Malaysia-based company Hartalega Holdings, which is a manufacturer in nitrile gloves used in the medical industry. As the biggest manufacturer of high-end disposable nitrile gloves in the world, a majority of its revenues come from the US and Europe, where stricter environmental regulations are being introduced. Over the years, Hartalega has consistently invested in best-in-class facilities that meet or exceed environmental standards; reducing its use of natural resources. Its health, safety and environmental performance regularly outpaces many of its peers, and it sets aside four per cent of annual profits to invest in equipment and technology to help protect the environment.”
ESG integration is so broad, so where to start?
“Given the state- and family-owned nature of many EM companies, the governance aspect is an obvious place to start; applying a ‘red flag’ system to highlight risks of corporate malfeasance that should be avoided. This is beneficial in terms of mitigating risks - corporate governance abuses are more frequent in certain emerging markets - and obtaining investment upside.
As EM companies move minority shareholders up the priority list, focus on better disclosures and implement more generous dividend policies, they should trade on higher multiples. That risk is almost automatically discounted for EM companies, so if those risks can be reduced, valuations should be higher. Then, if the investment decision making process can be expanded further to include environmental and social considerations, investors can embrace a broader range of risks and opportunities.”
Aviva Investments is the global asset management business of Aviva, with £348 billion in assets under management.
