ESG Ratings Can Help Investors Pick Winning Emerging Markets

If you’re not convinced that emerging market stocks and bonds are good investments at this point in the market cycle, as many market strategists believe, Morningstar has just delivered another reason supporting that outlook.

In its latest sustainability atlas, which measures the environmental, social and governance attributes of 46 different countries based on the companies domiciled there, adjusted for market weight, Morningstar gives high marks to several emerging market countries. Colombia, Taiwan, Hungary, Turkey and South Africa all scored above 60% of the countries rated by Morningstar, outscoring the U.K., Ireland, Hong Kong and the U.S., which is among the lowest rated developed countries for ESG factors.

The high ratings of many emerging market countries wouldn’t be such a big deal if there weren’t also growing evidence that companies scoring higher on sustainability measures tend to perform better.

“A sustainability agenda just goes hand in glove with performance of a company or an organization,” said Dominic Barton, the global managing partner of McKinsey, in a recent interview with the Harvard Business Review.

(Related: More Sustainable Investments Are Beating the Competition)

Now advisors who favor emerging markets and have clients who want to include sustainable assets in their portfolios can marry the two approaches more easily.

“Some investors think if they invest for sustainability factors they won’t get exposure to emerging markets, but there are bright spots,” says Dan Lefkovitz, Morningstar indexes strategist. “Colombia ranks in the top quintile.”

And there’s good reason to want that exposure. Emerging markets are expected to once again outperform developed markets, as they did last year, because of strong growth, a weak dollar (which helps those countries with dollar-denominated debt) and a rebound in commodity prices.

(Related: Emerging Markets Surging Into 2018)

GMO, the investment firm co-founded by Jeremy Grantham, forecasts that emerging market stocks and bonds will be the only major securities markets to post positive annual returns for the next seven years, and it recently revised those gains higher.

Not all emerging markets, however, are expected to outperform, which is why incorporating ESG issues could be key to developing winning EM portfolios.

(Related: Jeremy Grantham: ‘Be Brave’ and Invest in Emerging Markets)

“EM countries are more vulnerable to the ill effects of ESG issues as they have far greater exposure to extreme weather events (e.g. floods, droughts); resource scarcity (e.g., water, food); social unrest; corruption; and poor governance,” GMO Portfolio Manager Binu George and ESG Practice Manager Hardik Shah write in a recent report. They recommend that investors integrate ESG analysis to build EM portfolios that can withstand swings in economic and stock market volatility.

They note that the South African market, which had underperformed the EM asset class for the first three quarters of 2017, rebounded in the fourth because investors sensed that a change in corporate governance might be coming following the election of a new president replacing one accused of corruption. At the end of the third quarter the South African stock market was up 12.6% versus 28.1% for emerging markets as a whole, and by the fourth quarter it had gained 21.4% compared with 7.5% for the broader EM market.

“There is a relationship between strong ESG ratings and high quality and low volatility in emerging market stocks,” says Lefkovitz. “Across the world, sustainability is increasingly about value — not just values.”

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