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Emerging markets roundtable: An uneven recovery

Funds Europe – How are managers applying ESG across different EMs, what are the main challenges they face, and how does engagement with sovereigns differ with developed and emerging markets? What ESG issues do they face?

Varsani – Emerging market ESG ratings require a lot more consideration, given the scarcity of data. We don’t just rely on company disclosures, but also source data from alternative sources such as government websites and NGOs.

There is a strong contrast between ESG ratings in developed markets and emerging markets. We see Europe having the highest ESG ratings as a region, followed by the rest of the developed markets, and emerging markets are much lower. There are more large EM firms that are state-owned or have single principal shareholders, whereas developed market stocks tend to be more dispersed, so the underlying structure is very different. It’s not just about simply feeling more green, it’s about what financial value ESG brings in terms of risk and return. Within emerging markets, ESG leaders – the top-rated companies from an ESG point of view – tend to have stronger cashflow characteristics compared to laggards, and lower levels of systematic risk, so lower levels of volatility. They also tend to have lower levels of idiosyncratic risk as well, so less exposure to severe incidents, such as data breaches. When we look at ESG as a factor in EM, its outperformance is much greater than in Europe and the rest of the world. The financial materiality of ESG ratings in EM overall has been in the past much stronger than the rest of the world.

Cardinale – We’ve had challenges when it comes to availability of data in emerging markets, but that doesn’t mean that we shouldn’t try. We know ESG factors such as climate change and controlling shareholder structures are important drivers of risk and return and we think that in terms of risk mitigation, understanding exposures to ESG factors is particularly important. We look at it both from a top-down and a bottom-up perspective; the top-down is looking at countries and we attempt to create rankings according to a set of ESG-related factors with important bearings on financial returns. We look at corruption, the Human Development Index, environmental performance, economic freedom etc., all factors that have ESG ramifications but are also important when you are thinking about allocating capital to different countries. Then we also look at companies, we understand some companies are leaders and are really embracing ESG while others are laggards. There is a mix of reducing exposure to companies that we perceive as laggards but also engaging with them to make sure that they improve.

Slabber – At the end of the day, when it comes to economics, we all know that it’s the application of resources, in this case capital, most of the time. The bottom-up approach will probably work better for one specific reason, and there are two angles to come at this from. Allocation of capital from an ESG point of view should be a reward for actions and behaviour that’s already taking place. Unfortunately, if you start allocating resources directly to governments, there is a lot of window-dressing going on. In Western Africa, fraud, corruption and window-dressing are rife.

If I want to protect my investors’ money, I need to make very sure that I’m going to reward good behaviour and encourage that behaviour instead of falling for window-dressing that wants to attract the capital that I’ve got. Bottom-up works better, otherwise that money is going to go into a very deep and dark place and you may never see it again.

Bao – ESG criteria is more like a relative term because if you compare a company in the same sector across developed and emerging markets, you will see a huge degradation in terms of ESG scoring for EM companies, whether the data is supplied internationally by an ESG organisation or locally. You need to look at the historical evolution as well.

Availability of data is an issue. The international rating agencies on the ESG issues sometimes have very limited coverage on emerging companies. To give an example, the Chinese equity universe has around 7,000 names, while names that are scored by a third-party international agency such as Sustainalytics do not surpass 2,000 currently. We have a similar experience in India, so basically you need to find a second source of data locally or do your own proprietary research.

Spano – As a fund of funds manager, I must look at which third-party asset managers have the best ESG products or are following ESG protocols – some do well, but others get left behind. It’s important to understand the ratings of each one of the funds that I am looking at. Those that follow better ESG processes usually perform better. Still, the transparency that you have in emerging markets is not as good as developed.

As long as there are big institutions in emerging markets, they tend to be quite in line with all the ESG parameters. By the time you come down to small companies, they might seem very brilliant businesses, but one thing that worries most of the fund managers is whether they follow ESG protocols. That becomes crucial if some of those small companies only have one or two big stakeholders. Why? Because those markets are still not as efficient as the developed markets where you have a broad range of shareholders, so the interest of the minority investors is still protected. When you have one or two big stakeholders, then it becomes a big problem.