Investing for tomorrow

Applying Environmental, Social and Governance Principles to Emerging Market Debt

02 Aug 2017

Many investors put off at the idea of using environmental, social and governance (ESG) criteria when investing in emerging markets (EM). Pictures of wood-burning stoves polluting tropical air or military tanks in a coup d’etat are often the associations one has with emerging markets and run counter to the growing need for environmental sustainability and good governance.

Just a decade ago, most countries facing fragile situations (whether political, social or economic) were low-income. This situation has hugely improved, with human development indices and other metrics demonstrating significant progress as many countries have graduated to middle income status. If we look ahead, some of the poorest countries with the lowest ESG scores may in fact produce the largest improvements.

 

Combining the expertise of our Emerging Markets Fixed Income team and our dedicated Sustainability Centre, our ESG in emerging market debt (EMD) paper explores:

  • How – and why – we apply an ESG framework to EMD
  • Examples of the factors included in ESG screen
  • Incorporating ESG into the EMD investment process
  • The future of EM and the role of ESG

Without question, many emerging markets are departing from a lower base. We agree that many of these countries arguably face the lowest hanging fruit in terms of gaining environmental efficiencies, safeguarding social goods and improving institutions of government. But these are precisely the countries that are most in need of long-term responsible investment to stimulate economic growth, job creation and strengthen their economic foundations.

We think it is also possible that these countries harbour the best set of long-term improvers capable of generating outsized growth and asset gains for patient investors. Demographic trends and a growing middle class in many of them are generating rising demand for consumer goods, infrastructure, services and agribusiness, which provide new opportunities for investors.

MOTIVATION

How – and more importantly why – do we mould this asset class into an ESG framework? Firstly, the evidence is increasingly clear that ESG factors do improve investment returns. In fixed income, various studies have pointed out the sizeable contribution of governance factors to long-term returns. Environmental sustainability metrics similarly have been associated with outperformance. We believe an alpha case can be made for EMD as well based on the notion that sound policies and long-term planning lie at the heart of both sustainability and return on investment.

Secondly, investors should be aware that the future will not look like the past: there is no longer just a single EM group, which is a derivative of China, with poor countries converging to rich status slowly and surely over time. The reality is different: some countries are moving in a positive direction, with improving standards of living, strong policy frameworks and an institutionalisation of democracy; others are sliding down a deteriorating policy trajectory along which institutions as well as citizens will suffer. Here, an ESG framework helps us separate the wheat from the chaff, applying a forward-looking focus on long-term success that is different from our daily, alpha-oriented investment process. Such an approach sends a clear signal to countries of the increasing value investors accord to sustainability-related factors when forecasting economic growth.

A related point is this: there are two ways to generate alpha – overweighting the champions and underweighting the pitfalls. EM investing is not just about finding the best markets; it is also about avoiding the worst ones. Long-term sustainability, in our belief, is synonymous with minimising crisis or ‘blow up’ risk. Moreover, it is potentially harder to predict crises than it is to find alpha in EM given that the environmental, social and governance risks in the world have evolved. We cannot rely on past cycles and backtests; for the future, we must have a forward view on what will matter in this brave new world.

This brings us to our final point: investors do increasingly expect asset managers to wear ESG lenses. Asset holders’ ethos and views are increasingly shaping the industry. In many countries, the drive toward ESG-tailored investing is inescapable. Investors have grown sceptical of exclusion lists and are looking for a more innovative, nuanced implementation of ESG research.

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