ESG in Emerging Markets and Beyond: Where Is the Alpha?

If investing concepts earned prizes based on how much respectful indifference they receive from the investing community, environmental, social, and governance (ESG) issues might earn a trip to the winner’s circle.

Somehow ESG has yet to emerge as a fundamental driver of value. If the CFA Institute 2015 member survey on ESG is any guide, downside protection and investor mindset — not alpha — have been the key motivators of interest in ESG.

It isn’t a surprise that the world’s biggest active funds have relatively poor ESG rankings. While this could very well change, given the current lack of interest in ESG factors, any shift would likely result from end investor demand rather than a systematic investing approach. The who’s who of signatories to the Principles for Responsible Investment (PRI) of the United Nations (UN) confirms a trend: The world’s biggest government funds, perhaps supported by direct community interest, are at the forefront when it comes to incorporating ESG considerations in investing.

While other investing concepts — value investing, for example — have attracted devoted followers for decades, socially responsible investing (SRI) has failed to generate a similar level of idea- and action-driven momentum from the investment community.

The underappreciated nature of ESG considerations, particularly in emerging markets, is an attractive opportunity.

So Where Is the Money?

Geographically, 99% of the world’s sustainable investing assets are in the United States, Canada, and Europe. Though this statistic may not be wholly accurate, it suggests that there is significant underpenetration of ESG factors in emerging markets.

But how do ESG principles deliver value? There are several distinctive approaches, according to the practitioner literature. Chief among them are negative or exclusionary screening and positive or best-in-class screening.

Negative Screening

Businesses must follow environmental and social performance standards mandated by regulations. Deviations from these regulatory norms can have investment implications ranging from the negligible to the destructive. Almost every couple of years, companies with shallow ESG records end up as case studies in value destruction.

While the governance aspect in ESG is important, the environmental and social aspects in particular are a source of significant liability and potential value destruction. Due to the possibility of steep losses, avoiding problematic companies or sectors is the most common sustainable investment strategy. As of 2014, negative screening strategies accounted for about US$14.4 trillion of the roughly US$21.4 trillion sustainable investing assets.

Positive Screening

The market has yet to grasp ESG improvement as a source of alpha for an asset or security. With regard to emerging markets, and India in particular, Aditya Arora of GEF investment advisors has an interesting insight: It is relatively easy to identify companies at the extremes — those with either poor or fantastic ESG records. Most fall in the middle, and this middle ground offers opportunities to investors who are willing to look.

There are companies whose promoters have no intention to tighten ESG standards, while others have stakeholders who are willing to improve but lack the knowledge or the foresight to do so. Investors could work with these promoters on their ESG records, or look for changes in companies that are moving up the ESG performance curve. This can result in significant alpha to investors as they benefit from a valuation multiple expansion, better capital allocation, and improved cash-flow quality. It is similar to junk or high-yield investing — generating returns from high yield and price appreciation.

The Promoters

Capital sourcing and structural hurdles, including regulatory uncertainties, make it difficult to start and run businesses in emerging markets. Scaling a business to an internationally recognizable size is even more challenging. But ignoring ESG norms to build a business could create permanent walls against growth and capital formation. Investors in developed countries may not even consider companies with shaky ESG records.

Positive screening ESG opportunities may be easily available only in emerging markets. There are, however, broader principled stands managers can make, as some did when they avoided fossil fuel investments. Had others followed their lead, investors would have dodged the significant market correction and price swings of the last two years. The oil story is far from over — prices could recover, recouping the losses.

Still, avoiding unsustainable investment choices is not a theoretical fad but a robust downside protection mechanism and an attractive outperformance opportunity that deserves attention.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: ©iStockphoto.com/Konstantin Yolshin