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Fact or fiction: SI does not work in emerging markets

Fact or fiction: SI does not work in emerging markets

08-08-2018 | Insight

Sustainability investing is well established in the West, though some doubt whether it can work in emerging markets battling with bigger issues. In fact, experience shows that emerging markets present both a huge investment opportunity and a distinct set of environmental, social and governance (ESG) risks and challenges.

  • Guido Moret
    Guido
    Moret
    Active Ownership Specialist
  • Masja Zandbergen
    Masja
    Zandbergen
    Head of ESG integration

Speed read

  • ESG adoption has been much lower in emerging markets
  • It’s still possible to find sustainable equities and bonds
  • Better governance and impact investment is also helping

Environmental threats include mass urbanization and deforestation, while the continuance of child or slave labor along with low pay presents social problems, and high levels of state or private ownership give rise to governance issues. Some emerging countries can’t adequately feed their own people, let alone adopt solar power or electric cars.

This sense of how poorly sustainability is adopted in Asia, for example, is reflected in figures by the Global Sustainable Investments Alliance. It said that of the USD 22.9 trillion invested by its members at the end of 2016, just USD 52 billion or 0.2% was in Asia outside Japan.1

So, is there any point in trying to invest sustainably in these regions? In fact, these very problems make using ESG even more important when building emerging market portfolios, particularly in knowing where to look for the bright spots.

And it has an even greater effect: research shows that while adopting ESG factors in developed markets has a positive effect on corporate financial performance in 38% of cases, for emerging markets that positive effect is seen in 65% of cases. Addressing the governance factor was shown to have the greatest influence.2

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Figure 1 | Relationship between ESG and corporate financial performance

Source: Friede et al (2015)

One way of creating more sustainable emerging markets funds is by taking a quantitative approach through factor investing, as discussed in a 2017 white paper by the Robeco quant team, ‘Going for green alpha in emerging markets’. In practical terms, this is done by building a portfolio that is 20% more sustainable than the benchmark, with a 20% lower footprint for water use, CO2 emissions, waste and energy use. In addition, this method uses an extensive values-based exclusion list, excluding companies from industries such as coal, tobacco, gambling and firearms production.3

It can also be important to combine differing emerging market strategies for equities, using both a fundamental approach looking at traditional ESG factors, and a quant approach seeking factors such as low volatility, where some markets offer the same returns at a lower risk. This is discussed in another Robeco white paper, ‘Combining quant and fundamental to diversify your emerging market equity portfolio’.4

Targeting emerging debt

Getting reliable data to be able to make informed decisions is part of the battle. Robeco’s emerging markets team has built a significant database that can assess risks and opportunities when building portfolios, using a combination of top-down factors to analyze countries and bottom-up criteria to find the best securities.

For the top-down assessments, the team makes use of RobecoSAM’s Country Sustainability Ranking (CSR). This twice-yearly report looks at a range of factors that particularly affect emerging markets, including susceptibility to corruption, levels of internal dissent, relative freedoms of the press and vulnerability to commodity prices such as oil for economic success. It contains and all-country index and a bespoke emerging markets index. The bottom three nations in the October 2017 emerging markets CSR were Nigeria, Pakistan and Venezuela, while the top three were Singapore, Hong Kong and the Czech Republic.5

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Governance improvements

One area in which sustainability can be shown to have made a difference is in corporate governance improvements in Asia. Robeco has long engaged with investee companies to try to address issues such as the lack of women or independent directors on boards, or unfairly treating minority shareholders. Governance improvements have been so tangible in Japan and South Korea that stock market multiples are now expected to rise, Robeco reported in October 2017.6

Meanwhile, the adoption of voluntary Stewardship Codes in Asia which promote active ownership by investors has increased levels of engagement, voting at shareholder meetings, and exclusions of companies that don’t meet minimum requirements, generally raising standards.

Perhaps the last word should go to the authors of an influential research paper by the specialist ESG data provider Sustainalytics entitled ‘Bridging the gaps: effectively addressing ESG risks in emerging markets. “Emerging markets present both a huge investment opportunity as well as a distinct set of ESG risks and challenges,” they said.

“Although investors generally perceive ESG risks to be larger in emerging markets than in developed markets, they are applying responsible investment strategies to a lesser degree when making emerging markets investments. Yet, especially in the context of emerging markets, addressing ESG risks can be very rewarding for investors wanting to reduce portfolio risks or looking for investment opportunities.”7

1 Global Sustainable Investment Alliance, 2017 Review
2 Gunnar Friede, Timo Busch & Alexander Bassen, ‘ESG and financial performance: aggregated evidence from more than 2000 empirical studies’, Journal of Sustainable Finance and Investment, November 2015.
3 Wilma de Groot and Tim Droge, ‘Going for green alpha in emerging markets’, 2017
4 Fabiana Fedeli and Wilma de Groot, 'Combining quant and fundamental to diversify your emerging market equity portfolio’, 2017
5 For more information about how the CSR is compiled, go here
6Interview with Arnout van Rijn, Chief Investment Officer for Robeco Asia-Pacific Equities, October 2017
7 Andrea van Dijk, Lotte Griek and Chloe Jansen, ‘Bridging the gaps: effectively addressing ESG risks in emerging markets’, Sustainalytics, 2012.

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