Emerging Markets

Active ESG investing in emerging markets

Emerging markets are often seen as exotic, niche, risky parts of the market. While it’s certainly true that they are often more volatile versus their developed market peers; it’s also true that they offer potentially huge opportunities for long-term investors.
Maart 2020
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Risk Disclaimer 

The value of investments and any income derived from them can go down as well as up as a result of market or currency movements and investors may not get back the original amount invested.Investing in emerging markets is generally considered to involve more risk than developed markets. Screening out sectors or companies may result in less diversification and hence more volatility in investment values.

Emerging markets are often seen as exotic, niche, risky parts of the market. While it’s certainly true that they are often more volatile versus their developed market peers; it’s also true that they offer potentially huge opportunities for long-term investors.

But how should one think about balancing the conflict between the perceived risks and obvious potential? Is there a way for a smart investor to navigate these markets and find a more stable path and sustainable return? Yes – by actively investing and keeping ESG issues at the forefront of their decision-making.

Risk Disclaimer

The value of investments and any income derived from them can go down as well as up as a result of market or currency movements and investors may not get back the original amount invested.Investing in emerging markets is generally considered to involve more risk than developed markets. Screening out sectors or companies may result in less diversification and hence more volatility in investment values.

The growth story in emerging markets is well documented. Many of these markets have large and young populations, who are increasingly moving to cities and providing a catalyst for increased wealth creation. Brookings Institute estimates that the world’s middle class will swell by 2.4bn people to 5.4bn between 2015 and 2030 alone1 – and the vast majority of these new consumers will be in emerging markets. Increased wealth leads to increased consumption, and increased consumption translates into massive business opportunities.

 

Why it pays to be active here

The rewards of this story won’t be distributed equally between companies. Many will prosper, but others will struggle as competition intensifies. The greatest beneficiaries will be the highest-quality companies: those best placed to withstand the challenges of competitive and economic threats; those that can successfully exploit opportunities in both good times and bad.

Successful emerging market portfolios cannot be run from a desk. Visits to companies are essential to sift out the good from the bad; to determine what the key decision-makers are like – what are their ambitions and incentives? Are they looking for short-term rewards or do they have a more sustainable, longer-term vision? Last year we travelled to India to explore its vast and untapped healthcare market, among other opportunities. We believe that beyond reaping the financial benefits of a growing market and increasing revenues, companies can and should play an active role in improving peoples’ livelihoods by making services affordable and inclusive. We were pleased to meet a variety of healthcare service providers and pharmaceutical companies with impressive principles focused on awareness, accessibility and affordable treatment.

Visits also help investors establish trust and manage risks. This is particularly important in emerging markets because of the high percentage of family and state-owned businesses, both of which come with their own opportunities and – importantly – risks. There isn’t a hard and fast rule here: in India, private sector banks are the highest quality, whereas in Indonesia it’s the state-owned banks that persevere. It takes an active manager willing to leave their desk and do the research to make the best call here.

Use our handy glossary to look up any technical jargon you are unfamiliar with.

Investment decisions can and should reflect the sustainability challenges and opportunities companies face.

The benchmark is not your friend

An active approach also pays off in emerging market investing because tracking the benchmark, by contrast, is limiting for a number of reasons. Emerging markets are far from a homogenous asset class: they are a large group of distinct countries, economies, cultures and political systems. Tracking doesn’t provide this diversification – you aren’t really getting what you think you are. Benchmarks are heavily concentrated at the country level, fast becoming ‘China+’ with about 30-35% of their regional allocation there and set to increase to 45%.2 Meanwhile, an additional 24.4% is allocated to more developed markets (like Taiwan and South Korea). This misses out on the diverse nature of emerging markets and a huge amount of future potential.

There isn’t much room for diversification at the stock level either. The top five stocks in a typical emerging market benchmark represent 20% on the entire index3 leaving less space for other, lesser-known opportunities. And this leads on to another limiting factor: benchmarks reflect the past, showcasing traditional emerging market economies and companies that have made their development leap, such as Taiwanese companies, instead of what’s on offer in less developed companies that are poised to succeed as wealth expansion takes hold – the likes of Vietnam or India.

 

Manage risks and find opportunities with solutions to ESG issues

Investment decisions can and should reflect the sustainability challenges and opportunities companies face. Emerging markets require increased energy output as they develop, leading to more power plants and factories, and hence more strain on our natural resources and environment. We cannot expect our peers in the emerging world to curb their aspirations in exchange for a cleaner planet. Instead, a new approach is required – where economic progress is not just calculated on traditional revenue but also on whether companies are operating in sustainable ways to limit their negative impacts.

Active managers can triumph over index trackers here, conducting research to seek out companies that have a positive impact by either contributing to, or being positioned to benefit from, the solutions to sustainability challenges. These are typically companies focused on a long-term approach instead of those looking for immediate financial gain through unsustainable means – and a long-term approach often reflects a high-quality company, so the active manager wins again.

Finally, active investing goes well beyond seeking out opportunities in the sustainability space. Face-to-face meetings and open dialogue allow managers to encourage positive change at companies through engagement and voting, which is integral for creating sustainable returns over the long term. Our recent visit to Indonesia capped a year of successful engagement with a major bank there, which has made significant progress on improving its management of ESG risks and opportunities in corporate lending activities to high-impact industries, including palm oil. ‘Doing good’ is ultimately the core purpose of responsible investment and it must remain there.

 

1 https://www.brookings.edu/wp-content/uploads/2017/02/global_20170228_global-middle-class.pdf
Brookings Institute 2017

2 https://www.scmp.com/news/china/money-wealth/article/3039484/major-emerging-market-stock-indices-increase-weight-china
3 MSCI Emerging Markets Index, as at 31 January 2020

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Emerging Markets

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