ESG: Improving Your Risk-Adjusted Returns in Emerging Markets


The demand for environmental, social, and governance (ESG) or responsible investing (RI) is growing at a rapid pace with nearly USD 23 trillion of assets being professionally managed under RI as of 2016, an increase of 72% since 2012.1 Despite increased investor interest and relatively higher risk exposure to ESG issues, the lack of breadth and depth in corporate sustainability disclosures has led to exaggeratedly low ESG scores and hitherto restricted rigorous application of ESG integration strategies to emerging market (EM) portfolios. With regulatory momentum moving toward more transparent, relevant, and accurate corporate disclosures, and the increased use of technology to capture and analyze data, this sustainability information gap is quickly reducing in many EM countries.

In Part 1 of this paper, we make the case that this cannot come too soon for EM investing as these countries are generally both more vulnerable to ESG issues and less prepared to deal with them. From an active manager’s perspective, the ESG scores in emerging markets encompass a wide spectrum, thereby offering another avenue to add value. In Part 2 we establish that both macro and micro ESG issues can substantially impact the earnings potential of corporations. We also highlight the benefits of developing a proprietary ESG assessment framework over a reliance on off-the-shelf ESG scores from vendors. We also demonstrate, using a case study, how one can integrate ESG risks and opportunities with traditional financial analysis to enhance the overall investment process. We conclude by underlining our conviction that although ESG signals are worth integrating in all strategies, there are some strategies in which these signals have a greater impact.

Part 1: Why ESG?
Environmental, social, and governance or responsible investing discussions are often accompanied by a degree of confusion because participants cannot agree on what it involves: whether it improves returns, lowers the risk profile, or is just aimed at having a positive impact on all stakeholders. In its early days, RI started off as socially responsible investing (SRI) and had a primary focus of screening out companies or, in some cases, entire industries (e.g., tobacco) based on ethical or religious beliefs. It has now evolved into a practice of integrating material ESG data with traditional financial analysis to better manage risk and strengthen the investment decision-making process. Globally, seven ESG strategies, as defined by the Global Sustainable Investment Alliance (GSIA), are typically applied. These include screening based on negative, norms-based, or positive criteria; thematic and impact investing; active ownership; and ESG integration. Depending on the asset owner’s motivation, ESG investing could mean investing in businesses that generate positive social or environmental impacts (impact investing); screening out controversial businesses such as tobacco, weapons, alcohol, etc., from the investment universe (values-based investing); or employing ESG signals at the security and portfolio level with a goal of improving risk-adjusted returns (ESG integration).