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Force for good

Paul RobinsonA new white paper from Alquity Investment Management suggests the analysis of environmental, social and corporate governance can help to mitigate the risks associated with investing in emerging markets, says Paul Robinson, the firm's CEO and founder 

Emerging markets are becoming more integrated into the global economy and investors are increasingly attracted by their strong economic growth. The investment mind-set used in developed markets cannot be applied to emerging markets, however, because risks are more acute in the latter due to weaker regulatory frameworks. Investors therefore need to apply a new level of thinking when approaching emerging market investment opportunities.

A new white paper produced by Alquity Investment Management in conjunction with Cass Business School illustrates how the analysis of environmental, social and corporate governance (ESG) is one solution to tackling investments in emerging markets. Better investment decisions are likely to be made through the careful consideration of a company’s adherence to ESG standards.

“The mere act of disclosing ESG policies tends to improve a company’s stock performance and its attractiveness to a foreign investor.”

The study shows that emerging market companies are increasing their level of transparency on ESG under pressure from regulatory supervision, institutional investors and a range of stakeholders. This will increase investor confidence in emerging markets. Using Bloomberg data, the study identifies how higher risk-adjusted returns are associated with companies with high and improving ESG disclosure scores. Clearly, investors will reward companies that are more transparent on ESG matters.

The study has also quantified the added benefit of having ESG analysis incorporated in the investment process. In a control experiment, ESG strategies were found to outperform the benchmark as well as similar strategies lacking the ESG criteria. The ESG strategies recorded higher average returns and lower volatility over the study period. The study therefore concludes that ESG analysis is essential for emerging market investors looking to beat the market and minimise downside risk.

The paper is not without its limitations – for example, companies’ own ratings on ESG issues were not used due to the subjective nature of available data. Instead, simple disclosure data on companies’ ESG activities were used as a proxy. This was based on the assumption that companies that act in an ethical and responsible way are also more transparent in their activities.

Nevertheless, the paper concludes there is a strong case for ESG analysis in emerging markets investing. Future research should be geared towards producing an objective scoring framework that measures a company’s impact on the environment, its interaction with society and its corporate governance standards.

Additional research should also be conducted to determine which of the three ESG factors of environmental, social and corporate governance is most important in determining stockmarket and accounting performance.

Alquity believes that the paper makes two important points. First, investment managers can improve their portfolio performance and risk-adjusted returns by integrating ESG factors into their investment process in emerging and frontier markets. Second, the mere act of disclosing ESG policies tends to improve a company’s stock performance and its attractiveness to a foreign investor.

Their message therefore is that ESG can, and should be, a priority for both companies and investors. They urge governments, regulators and international investors to encourage companies to embrace ESG disclosure to drive the growth of, and investment in, responsible, successful businesses.

Alquity advocates that ESG is a force for good because it enhances performance and that this is more important than ever, as we navigate volatile and risky emerging markets in search of the successful companies of the future. It is also important for attracting international institutional capital to emerging economies to drive wealth creation and opportunities.

The white paper ‘Does ESG enhance returns in emerging and frontier markets?’ by Roberto Lampl, head of Latin American investments at Alquity and Niccolò Bardoscia and John Munge, MSc students at Cass Business School may be downloaded here

Three key findings from ‘Does ESG enhance returns in emerging and frontier markets?’

1. Emerging market companies have lower levels of ESG disclosure compared with companies in developed markets – however, there has been a greater rate of improvement in the level of disclosure in emerging markets over the past five years.

2. There is a greater amount of dispersion regarding the amount of ESG disclosure within the emerging market universe. Companies with high and improving disclosure deliver higher equity returns versus their peers.

3. A strategy focusing on ESG coupled with fundamental analysis outperforms the broad indices with lower volatility characteristics – in other words, it generates higher risk-adjusted returns.

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