As pensions and real-money investors embrace environmental, social and governance (ESG) principles, applying them into emerging markets presents unique challenges for managers.

“It is a complex topic when it comes to sovereigns,” describes Salman Ahmed, chief investment strategist, Lombard Odier Investment Managers, which manages US$47.8 billion of assets on behalf of the Swiss-based Lombard Odier group.

He adds that the yardstick used to assess sovereigns is quite different from corporates. ESG is also a developing field. Methodologies are being constructed and tested. In some areas, such as in the case of corporates, it is quite rich. “When it comes to sovereigns, we have done quite a bit work internally. We are focused on the E part of ESG or environmental.”

As you start assessing these emerging markets based on criteria shaped by investment values, Ahmed points out, then you lock yourself out of 95% of the emerging-market countries. “The environment side is quite interesting and relevant because tangible signs of climate change are happening and have links to macro outcomes.

Most of these emerging markets are exposed to climate change, especially the more populous ones in Asia. There is a lot verifiable data available – carbon intensity, sustainable development goals (SDG) and other World Bank indicators.”

But there is still complexity in how to apply that to portfolios because there are still a lot of hidden variables, he says. “If you rank these countries, say in fixed income using GBI (JPMorgan Government Bond Index) and if you include India and China as well, you might as well rank those countries on a per-capita income basis – countries that are poorer will have lower SDG scores; you might as well not use any ESG criteria and reward/punish these countries on the basis of per-capita income.”

Ahmed says that his firm therefore has to apply “sophisticated investment machinery to take those pseudo effects out and to see what the rankings of these countries actually are, based on the various variables”. He adds that the key is the E part of ESG that has some kind of impact on future performance rather than the S or the G when it comes to the larger emerging markets.

On the equity side, Ross Teverson, head of strategy, emerging markets, Jupiter Asset Management, which has US$71.5 billion in assets under management, says that people care a lot about ESG because clients care about it. “I have always been asked about governance because there is this understanding among clients that governance is an important part of long-term investing in emerging markets. Ideally, you have a good alignment of interest between management and minority shareholders.”

There is increasing awareness on E and S, he says, because there is a great push from clients to make sure that they can report to their end-customers that they take these things into account. Teverson is of the view that governance in the emerging markets has improved a lot over the past two decades. One of the easiest ways to prove that is to look at the proportion of companies paying a dividend. “When I started investing in emerging markets in the late 1990s, at the time 40% of companies paid some sort of dividend. Now, that is closer to 90%. Cash coming back to us is the single best measure or evidence that there is some alignment between management and us as minority shareholders.”

In China, Teverson agrees that when the topic of governance is discussed, the question is can the numbers be trusted? “There have been some case studies in the past that have made investors understandably quite wary that companies in China audited by some of the big accounting firms have been lying about their cash balances. As an investor, you always have to be slightly cautious, do your due diligence to make sure that you are avoiding those types of cases of poor governance.”

He argues that those have become less common. It has been a while since we have had an accounting scandal like that in China. Overall, governance is improving even in state-owned enterprises. “China Unicom, which is the second largest mobile operator in China, has recently introduced a management share-based incentive scheme that sets very clear targets for net income growth over the next three years. You have a state-owned enterprise, which previously could just have been a tool of state policy. Now you have a management team that are very clearly incentivized to grow profits and increase value for shareholders.”

Focusing on governance is very important and a good thing to do when it comes to emerging markets, argues Arnab Das, head of emerging markets and EMEA macro research, fixed income, at Invesco, which has US$934.2 billion of assets under management. Taking a step back, he says the difference between ESG in emerging markets – in China and India in particular – compared with the developed markets is that when poor governance issues emerge in countries with strong institutions and the rule of law, something changes. “Somebody goes to jail; a price is paid; rules are tightened, and things hopefully change, and we don’t have a repeat of the same sort of crisis,” he points out. “In countries with weaker institutions, where the state is involved in large swathes of the economy and very close to many large corporations, it may be quite difficult to make those kinds of changes.”

That is the core reason, he thinks, why you would have a stronger misalignment of minority shareholders’ interest with the majority shareholder. “If you are running a company for a state, presumably you are running it in the public interest. But if the state itself is an authoritarian entity, or the institutions of the state are not necessarily geared towards what you might generally describe as the wider public interest but a much narrower public interest, which is in the case of many emerging-market countries, it may be quite difficult to get that alignment right. You may be able to persuade people that you are doing that by paying them a dividend and it may even be true. But there will be some doubt about that, and therefore there will be a discount for that governance issue.” 

 

This article is an abbreviated version of Wly China and India remain in favour published in the April print edition of The Asset and available on The Asset Plus.