Executive Summary

ESG integration is best used as a tool to improve portfolio returns and/or reduce risk. While usually thought of as a company-level concern, material ESG data can be very useful at the country level as well, especially in emerging markets. ESG signals are only as good as the quality of their inputs. Portfolio managers therefore need to determine which ESG inputs are material to their specific investments and not rely blindly on third-party ESG ratings. They also need to establish a process to resolve any conflicts with other fundamental signals, for example, via company engagement. Performance attribution of ESG signals, at least in the short run, requires both qualitative and quantitative analyses.

Over the last couple of years, as we have systematically applied material Environmental, Social, and Governance (ESG) signals into the investment process of our GMO Emerging Domestic Opportunities (EDO) strategy, we have learned several key lessons that reinforce our original research thesis and help us maintain our enthusiasm over having this more robust toolkit moving forward.

Lesson 1: Country ESG Risks Can Be Highly Material

Country allocation can be a very powerful driver of returns. We studied the difference in country performance relative to the MSCI EM index over a typical 3-year period and discovered that if a manager is able to identify and allocate to the 10th best performing country while avoiding the 10th worst country, the resulting spread is an impressive 8% per year in emerging markets.

ESG performance varies widely across emerging countries. Taiwan, for example, scores significantly higher than China. ESG therefore provides us an opportunity to add differentiation along a dimension that can matter quite a bit to returns.

At the country level, our evaluation is based on both long- and short-term models. The long-term models include factors that we believe will impact the prospects and health of an economy in the long run. ESG signals such as the quality of institutions and political capacity are already included as we know these are critical to the long-term attractiveness of a country. After deciding to take a more comprehensive view of ESG, signals related to air pollution, water stress, and national climate policies along with social signals related to health, education, and equality were added to our long-term country evaluation models.