Emerging Market Equity and the ESG Challenge

bfinance insight from:

The resurgence of investor appetite for emerging markets is proving to be the most significant allocation trend of 2017, at least according to bfinance data on new mandates. The positive macro tailwinds witnessed in the aftermath of President Trump’s election have simultaneously sent emerging market equity to the top of the performance rankings - especially those with lower exposure to Brazil or commodity-sensitive markets such as Russia.

Yet there have been significant changes since the last great surge in investor appetite for emerging markets in 2009-10, such as the greater feasibility of segregated accounts thanks to improved market liquidity, the deepening bench of specialist regional and country managers and the stronger investor demand for top-down macro insight.

One of the most noteworthy developments, however, is the increasing relevance of ESG in this space. Below, the bfinance equity team – Justin Preston (Managing Director), Joey Alcock, Julien Barral and Rob Doyle – debate the developments.

Is ESG linked to outperformance in emerging markets?

Joey Alcock: “Do ESG-oriented emerging market equity managers produce better returns? There has been quite a lot of publicity this year around the performance of the ESG-focused MSCI emerging markets index, which has beaten its non-ESG counterpart. I’d be very wary about that finding, particularly in light of recent commodity price dynamics.”

Rob Doyle: “There does – at least on the surface –appear to be a positive correlation between managers’ governance scores and investment performance in bfinance emerging market equity manager analysis in 2017. It’s not robust enough to conclude that there is a connection, but it is interesting. There’s certainly a stronger connection between ESG and performance than we find in developed markets.”

Julien Barral: “To be honest, we were initially quite surprised that the managers scoring highly in our ESG analysis, particularly on the governance side, were all also performing very strongly in non-ESG EM equity selection processes.”

Joey Alcock: “Yes. It was also interesting that some of the managers that scored well in this ESG analysis had not received good scores from PRI (Principles for Responsible Investment). This community is currently playing catch-up in terms of disclosure and communication of the way in which ESG is integrated. It also underpins the importance of not placing too much weight on those PRI scores when considering ESG, as noted in the recent paper ESG Under Scrutiny: Lessons from Manager Selection.”

What are the major obstacles to ESG integration?

Justin Preston: “When it comes to the integration of ESG criteria, investors should not expect processes to compare with their developed market counterparts. That being said, the governance element (the “G”) has always been very significant in emerging markets, particularly given the crises of the 1990s. This does not just apply on a corporate level but on a country level also - we see managers that will rule out entire countries on a governance basis, such as Russia.”

Joey Alcock: “One of the greatest difficulties that managers face is the lack of data. Companies in developed markets recognise that ESG-related issues are a major concern for shareholders: they report on the relevant criteria. There is simply less ESG-related information available from emerging market companies. Providers such as MSCI produce ESG ratings but those scores are often based on less information. Furthermore, they’re usually restricted to benchmark stocks – the ones in the index – while many EM managers invest a significant proportion of assets off-benchmark. The way in which managers deal with that data challenge represents a significant differentiator in terms our ESG assessment. Those that are proactively dealing with these weaknesses, such as developing in-house ratings rather than relying on external suppliers, will tend to score more favourably.”

Justin Preston: “This also ties back to overall manager strategy and style. Those with more concentrated, higher conviction, low turnover portfolios will find it more straightforward to assess ESG in emerging markets than those with a more diversified approach.”

What does it cost?

Julien Barral: “The quality of ESG integration is not linked to higher fees in emerging market equity. The median fee quoted for all global emerging market equity searches so far in 2017 (prior to negotiation) has been 69bps; the median quoted fee for ESG-specific searches was just above 70bps. As shown in the chart below, which gives data for three specific equity searches this year, other factors – such as mandate size and structure – make a far greater difference to fees than the ESG dimension.”

Justin Preston: “Interestingly, emerging market equity manager fees overall have shown surprising resilience, at least according to our data from live manager selection engagements. Many managers have been suffering from outflows during 2015-16 but they haven’t, as a rule, been dropping their prices.” Click Here for further insight on manager fees.