• ESG issues are rapidly becoming a key priority for companies in emerging markets.
• ESG analysis provides a window into the quality, leadership and focus of companies including disclosure and governance.
• Recent studies highlight how emerging market companies with sound ESG practices have outperformed.
• There is room for improvement, offering active managers a real opportunity to add value by identifying companies with good and improving ESG.

Environmental, social and governance (ESG) factors, a long-held concern in developed economies, are swiftly rising up the agenda in emerging markets. The challenges may be of a different scale but recent studies show that there are rewards for asset managers who engage with companies seeking to improve their ESG performance.

20 years ago, emerging market economies were on the brink of a commodity-fuelled boom, an era characterised by trucks digging coal out of the ground and polluting factories processing steel. Mindsets are rapidly shifting. From politicians to investors, stakeholders are thinking more holistically about sustainable economic growth. As part of this, ESG analysis offers investors a valuable quality lens into companies, their leadership, strategic focus, standards of operational practice and their ability to respond to the risks and challenges inherent in business; if you like, an insight into how well a business is being run and positioned to create sustainable returns.

The good news is that things are changing for the better. In 2016, China unveiled an ambitious fiveyear plan for ecological and environmental protection. In Brazil, Operation Car Wash, an anti-corruption project of unprecedented scale, was launched last year by authorities in the wake of the Petrobras bribery scandal.

At company level, management is much more aware that it is not just what companies say but what companies do that counts. There is also an increasing awareness that neglecting ESG issues has proved to have consequences, resulting in fines or worse, such as Honhai's persistent labour issues. In the extreme case of Petrobras, a bribery scandal had implications for the entire Brazilian economy.

In each of the last two years, our emerging markets equities team has met with more than 600 companies. We have seen an increasing level of engagement from companies. Some now pro-actively seek our advice and opinion on what we think of their ESG credentials.

ROOM FOR IMPROVEMENT

The central challenge for portfolio managers investing in emerging markets is that the ESG standards can be dramatically different to those in the West. Disclosure, for example, is usually poor. Annual reports tend to contain little information and be less consistent than their developed market counterparts. As a result, change in attitude towards ESG issues can be difficult to capture and data analysis is challenging. Consequently, assessing companies depends on having a dialogue with them.

In typical ESG analysis, there are standards for best practice. But in a lot of developing countries poor governance structures and disclosure are commonplace. This does not mean shying away from investing in emerging markets, but rather adopting a strategy of 'eyes-open and engagement,' and being realistic about the limitations.

Governance is typically one of the most significant tests, given its relevance to the stewardship of the capital we are investing. This is often where we find we can have the most impact and, as an active investor, where we have used our influence to engage with companies.

We raise questions and engage across a range of practices, such as non-independent transactions, inefficient capital structure, excessive remuneration, labour issues, supply chain concerns and pollution - all of which we have addressed with different companies over the years.

Questions on these concerns do not always get an immediate answer or solve the problem, but they are listened to and it is evident that attitudes are changing very quickly, especially in recent years. For us, the openness and response to this engagement can be telling.

REWARDS OF ESG INVESTING

What's most exciting is that the 'mountain to climb' scale of these issues creates a big opportunity for committed investors. Historically, one of the criticisms of factoring ESG into investing has been that it sacrifices returns. However, our experience that it doesn't is backed by a growing body of evidence showing that the opposite is true. Strikingly, the opportunity is often amplified in emerging markets.

This was illustrated in a 2016 study by Cambridge Associates, which found that the MSCI Emerging Markets ESG Index outperformed the flagship MSCI Emerging Markets Index in its inaugural three years, and more than half of this outperformance was attributable to ESG factors (see below). These included carbon emissions, product safety and business ethics.

Figure 1: Emerging markets over three years

Sources: MSCI Inc. and Thomson Reuters Datastream. MSCI data provided "as is" without any express or implied warranties.¹

In a nutshell, there is no need to sacrifice returns when investing with an ESG lens - by contrast, there is an opportunity to add value. It is not always a straightforward relationship but, put simply, there is more opportunity to add value and avoid risk than in developed markets.

For active managers, ESG analysis offers opportunities not only in identifying mispriced securities, but also helping us invest in companies that are well-run and changing for the better. Engaging with companies allows active managers to identify those that offer us a higher-quality, longer-term proposition for investment.

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¹ https://www.cambridgeassociates.com/press-release/esg-factors-have-helped-investors-achieve-significant-outperformance-in-emerging-markets/