ESG ‘Key’ to Outperformance in Emerging Markets

Environmental, social, and governance factors can have a significant positive impact on emerging markets portfolios, says Cambridge Associates.

Looking for an edge in emerging markets? Try environmental, social, and governance (ESG) investing.

Investors who picked stocks based on ESG factors in emerging markets over the last decade were likely to outperform those who did not, according to a new report from Cambridge Associates.

The study, which compared the performance of two MSCI emerging market indexes over the last three years, found that the ESG index outperformed its parent index by a cumulative 12 percent on a total return basis. More than half of that outperformance was attributed solely to ESG factors such as renewable energy and business ethics.

Further analysis of emerging market companies indicated that companies with higher ESG ratings outperformed in the preceding six-and-a-half years as well.

“Of the 367 basis points of annualized outperformance achieved by the MSCI Emerging Markets ESG Index, some 199 basis points were attributable to ESG factors after we accounted for the contribution of other factors such as country, currency, sector, and style,” said Chris Varco, senior investment director for mission-related investing at Cambridge Associates.

This finding, Varco continued, refutes the “assertion that ESG factors are just proxies for other things, rather than valuable investment tools in their own right.”

While evidence for ESG outperformance in developed markets has been mixed—MSCI’s global ESG index slightly underperformed its parent index—Varco argued that these factors are a “key tool” in emerging markets.

“Investors in emerging markets equities often focus on commodity prices, currency, and macroeconomic factors, as well as domestic consumption trends, and they tend to underestimate the value of this widely available information on the ESG strength of companies in emerging markets,” he said.

The MSCI ESG index, for example, weeds out state-owned enterprises, which feature prominently in MSCI’s broader emerging markets index.

“Where underlying ESG risks are higher,” Varco wrote, “the emergence of new robust datasets represents an important tool in the stock selection process.”

cambridge associates emerging markets esgSource: Cambridge Associates‘s “Evidence for Emerging Markets Equities

Related: The Search for Edge in Emerging Markets & The ESG Takeover