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The materiality of ESG factors for emerging markets equity investment decisions

This report presents the results of a study performed by the European Centre for Corporate Engagement (ECCE) in cooperation with NN Investment Partners (NN IP) to understand how environmental, social and governance (ESG) factors affect share price performance in emerging markets equities and to help implement a successful ESG-focused investment policy within the asset class. This unique empirical study focuses on evaluating the performance of emerging market equity portfolios that are formed using ESG criteria. We summarize the most important findings below.
The materiality of ESG factors for emerging markets equity investment decisions

Executive Summary

This report presents the results of a study performed by the European Centre for Corporate Engagement (ECCE) in cooperation with NN Investment Partners (NN IP) to understand how environmental, social and governance (ESG) factors affect share price performance in emerging markets equities and to help implement a successful ESG-focused investment policy within the asset class. This unique empirical study focuses on evaluating the performance of emerging market equity portfolios that are formed using ESG criteria. We summarize the most important findings below.

 ESG scores for emerging markets display size, sector and country (location) bias that can have implications for portfolio construction and performance. Emerging market ESG scores vary particularly across countries and sectors. Hence, using ESG criteria in portfolio selection without proper adjustments may lead to undesirable geographic and sector tilts in equity portfolios.
 When adjusted for country/sector effects, high absolute levels as well as positive changes in ESG ratings can lead to positive relative performance in emerging markets. Positive returns to absolute ESG scores is in contrast to the experience in developed markets.
 Aggregate governance ratings are a poor indicator of performance. Concentration of ownership is a better potential indicator as it gives an indication of the ability of one individual person or organization to influence company strategy.
 The exclusion of firms that have exhibited significant controversial behavior may have led to improved portfolio performance over the research period.
 Across most factors, portfolios with high relative ESG ratings in emerging markets yielded better relative returns than the similar studies found in developed markets.


Introduction

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. We believe, however, that the asset management industry has an obligation to hold emerging market companies to account on ESG factors, which will play an increasingly important role in investment decisions. This study, an ECCE-NN IP collaboration, is the first comprehensive investigation into the performance of emerging market equity portfolios formed on the basis of various ESG criteria. Academic research to date has focused almost exclusively on the impact for developed market companies. The general assumption is that while corporate governance standards and practises are important considerations when investing in emerging markets, companies and investors pay little attention to environmental and social factors and, as a result, relative returns to these factors are likely to be negative.

There are at least two reasons why studying the materiality of ESG information in emerging market equity selection is important. First, there is a growing demand for ESG portfolios that cater to investors interested in asset classes that stretch beyond global stock universes, such as emerging markets. Therefore it is important to understand how the investment performance of emerging market portfolios is affected by ESG considerations. Second, it is doubtful that evidence based on studies in developed markets will be a good guide for emerging market portfolios. Emerging markets potentially face fundamentally different ESG challenges, and companies operating in these environments can address different risks and opportunities by integrating environmental and social factors in their strategy and business models. In addition, ownership structures for emerging market companies tend to be different, and understanding the governance track record and motivations of these owners is an important factor in stock selection.

The main focus of this study is to evaluate the returns of various EM equity portfolios, each of which is formed using one of several possible ESG criteria for stock selection, in order to identify which ESG factors may or may not work in creating successful investment portfolios. Building on an earlier report, which shows ESG ratings can vary by size and sector, we normalize our study for size. We then look at sector effects. But to tailor the study more specifically for emerging markets, we also look at country influences. Additionally, the report considers the impact of a specific driver of corporate governance. And finally we look at the impact on portfolio performance from excluding companies that have had more serious breaches of best ESG practices, reflected in higher controversy scores.


Data description

This study draws on ESG data from Sustainalytics, corporate governance data from Governance Metrics International (GMI, now part of MSCI ESG Research), and stock returns data from Factset. Sustainalytics and GMI are currently the primary suppliers to NN IP of data on corporate ESG scores and underlying indicators. Sustainalytics provided us with all indicators fundamental to their aggregated ESG scores known at the start of each monthly interval running from January 2010 to October 2015. The ESG database used in this study covers all companies scored by Sustainalytics that are in the MSCI Emerging Markets index. The first date with EM coverage is September 2011, and the number of firms scored in EM increases over time from 650 in June 2012 to 751 in June 2015.

Sustainalytics also provides ESG indicators on controversial business practices (“Controversies”). Sustainalytics evaluates firms along a newly identified controversy by rating firms on a 0 (“no controversies found”) to 5 (“severe controversies found”) scale. Controversies refer to evidential controversial behavior of companies such as environmental pollution, bribery and corruption, human rights issues, etc.

Besides using ESG data from Sustainalytics, this study uses corporate governance data from GMI as a more specialist measure of the specific building blocks of overall governance performance. This is augmented with an analysis of ownership structure and control, a governance issue that is a priori arguably one of the most important factors in emerging markets.


Main results

Following a similar comprehensive research study in developed markets, we know that it is important to adjust for size when looking at relative returns to ESG factors. The results in Figure 1 suggest that the skepticism about looking at ESG in an emerging market context is well-founded. The Sharpe Ratio (a measure of risk-adjusted return) for a portfolio of low-scoring ESG stocks in fact is higher than for a high-scoring portfolio.

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Source: ECCE & NN IP Research, Sustainalytics, Datastream





To download the full report, please click here.


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