Investing in emerging markets (EM) equities with high environmental, social and governance (ESG) ratings leads to better performance when adjusted for country and sector factors, analysis1 in a new report from NN Investment Partners (NN IP) shows.
The analysis 1 found that companies with a high ESG rating have delivered higher Sharpe ratios. The report, entitled The Materiality of ESG factors for emerging markets equity investment decisions: academic evidence and conducted in association with the European Centre for Corporate Engagement (ECCE), is the first comprehensive investigation into the performance of emerging market equity portfolios using ESG criteria.
It found that the gains from investing in companies with higher ESG ratings are stronger in EMs than in developed markets (DMs) while ownership structures of companies is the most important corporate governance driver.
Jeroen Bos, Head of Equity Specialties at NN Investment Partners: “This new report confirms a number of important findings from our prior report on ESG factors in DM equities. We have now found a clear, positive relationship between incremental changes – or momentum – in a company’s ESG scores and investment performance in both developed and emerging markets. Excluding companies with controversial ESG behaviour also resulted in an uplift in Sharpe ratio, similar to our experience in Developed Markets. The implication for investors is to consider both level and changes in ESG scores when constructing an emerging markets equity portfolio as both factors contributed to risk-adjusted outperformance.”
The Report says that portfolios should be adjusted to take account of the fact that countries and sectors have a wide variety of ESG ratings because of different cultures, regulatory regimes, ownership structures and business practices. An unadjusted portfolio of high ESG-rated stocks would inevitably have a large overweight to certain countries or sectors, skewing the performance, the analysis shows.
Nathan Griffiths, Senior Portfolio Manager in NN IP’s Emerging Markets Equity Boutique at NN Investment Partners commented: “It is important to understand how the performance of EM equities is affected by these ESG factors because there is growing demand among ESG investors for a broader choice of assets. Furthermore, the ESG challenges at play in EMs can be very different to those in DMs. But in general, if a company makes a meaningful effort to improve its ESG policies then it can, on average, expect better relative share price performance.”
Emerging market companies are often assumed to give little or no consideration to the sort of sustainable practices that are increasingly considered an essential requirement for companies in developed markets. However, the asset management industry has a role to play in holding emerging market companies to account on ESG factors, which will play an increasingly important role in investment decisions.
Jeroen Bos concludes: “We are proud to have added new insights into the effect of ESG factors on the performance of emerging markets equity portfolios. Our next research project with ECCE recently started in which we investigate the effects of ESG factors on risk-adjusted performance in corporate bond markets.”
1Source: ECCE and NN IP Research, Sustainalytics, MSCI ESG Research and Datastream. Data tracked from January 2010 to October 2015. The data used in this research was based on data from 650 companies in Emerging Markets in June 2012, which increased to 751 companies in June 2015.