Sustainable investors outstrip emerging market benchmarks

Turbulent times for emerging markets are proving a boon for "sustainable" equity investors who shun companies that damage the environment, ignore labour standards or take a cavalier attitude towards corporate governance.

Indices tracking the share price performance of EM companies that pay attention to environmental, social and governance (ESG) criteria show a sharp outperformance over peers that do not bother. A similar premium is evident in investor returns for EM companies that regularly pay dividends to shareholders over those that do not, according to recent research by Standard & Poor's, the rating agency.

The tough EM market environment accentuates the return for "sustainable" investing because a focus on risk management is particularly important in choppy conditions, fund managers said.

"The outperformance of [sustainability] indices makes sense to us," said Gary Greenberg, head of Hermes Emerging Markets, a fund. "Who would want to own companies with poor standards of governance, who pollute, and who mistreat their employees and disrespect the communities in which they operate."

The MSCI Emerging Markets ESG index, which is comprised of 355 companies that meet ESG standards, was up 7.05 per cent in the year to the end of March, compared with a 0.79 per cent rise in the benchmark MSCI EM index, according to MSCI data (see chart). Another sustainability index, the DJSI Emerging Markets index, was up 3.97 per cent in the year to end of March.

ESG indices are not developed to serve an ethical agenda, but rather to select reliable firms to defray investment risks, said Emily Chew, head of ESG Asia-Pacific at MSCI. "The indices filter out the worst companies, those highly exposed to risk and with weak and poor management systems," she said.

Hundreds of "sustainability" criteria are applied to screen companies for admission into the ESG index, with a different set of standards for each industry. For example, a mining company that relies on water but operates within a depleting water basin may not qualify, she said. Big emitters of carbon that have not taken potential changes in emissions regulations into account may also fail to make the index, she said.

On social issues, health and safety is key. Companies that devalue health and safety standards open themselves to legal claims, while those that skirt insurance requirements are similarly exposed. In terms of governance, the structure of the board is assessed for potential conflicts of interest and dominant shareholders, Ms Chew said.

Guido Giese, head of indices for RobecoSAM, which creates sustainable indices for Standard & Poor's Dow Jones, said: "ESG has two sides: an ethical side and a business side. Our starting point is that we make sense from a business perspective."

In the case of carbon dioxide emissions, for instance, RobecoSAM selects companies that emit the least carbon dioxide per unit of output because "more and more governments impose a price for CO2 emissions, so being an inefficient producer is bad for business".

Mr Greenberg adds: "The EM managements who haven't yet come to terms with the rights of minorities, for whom employees are interchangeable cogs, and for whom the environment is a free externality to be exploited in the quest for better margins tend to be shorter term, transaction oriented managers focussed on short-term gains, not builders of great businesses."

A similar dynamic can be seen among companies that pay dividends, versus those that do not. Dividend payments are traditionally associated with developed market (DM) companies, but in fact EM corporations are now more assiduous dividend payers than their DM counterparts, according to a study of dividends over the past 16 years conducted by Standard & Poor's.

"The percentage of dividend-paying companies in developed markets varies between 60 per cent and 70 per cent. The figure is more dynamic in emerging markets, where the percentage of companies paying dividends has steadily increased from 60 per cent at the beginning of the measurement period in 1998 to between 70 per cent and 80 per cent in 2014, surpassing the levels observed in developed markets," according to Qing Li and Aye Soe at Standard & Poor's.

According to their calculations, emerging market dividend payers delivered annual average returns of 15.79 per cent, compared with 3.52 per cent for non-dividend payers and 12.96 per cent for the broader market in the 16 years to the end of 2014. In addition, dividing dividend payers up into five groups (with the top dividend yield payers in the first quintile), the cumulative performance of such shares reflects the generosity of the dividend (see chart).

"(This) supports the assertion…that dividend-paying securities offer a degree of downside protection during volatile markets," wrote Qing Li and Aye Soe.

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