Sustainable EM equity requires a steady compass

Many institutional investors have allo­cated a smaller percentage of assets to emerging markets than the gro­wing economic importance of these regions warrants. Lack of transpa­rency, high volatility, and governance concerns are frequently cited as re­asons. Additionally, recent concerns about China, along with a prolonged period of weak performance across the asset class, have led some inves­tors to reduce their exposure further.

Geopolitical tensions and recent dis­ruptive US import tariffs have added to the negative sentiment. Despite these challenges, emerging mar­kets still offer strong diversification and growth potential. For sustaina­ble investors, there are ample impact opportunities, as underscored in a roundtable discussion organized by Pensioen Pro.

The ESG roadmap to emerging markets

For sustainable investors, a key chal­lenge in emerging markets is the lack of reliable data, which compli­cates company selection and im­pact measurement. Additionally, long exclusion lists can create difficulties. What should investors do when ma­ny companies or entire countries fail to meet their ESG thresholds?

Another issue: Can emerging markets be approached passively, or do they require a more costly active strategy? This topic is especially pressing now that the Dutch Future of Pensions Act (Wet toekomst pensioenen, Wtp) heightens participant awareness of costs and re­turns, states Jeroen van der Put, board member of Centraal Beheer APF.

Van der Put: “I have had some good experiences with active mandates for several pension funds, but when you look at performance, you have to deal with the fact that only 20% or 30% of active managers deliver outperfor­mance. On average, pension funds pay about 40 basis points in costs. That leads to debates on performan­ce fees. So one of the first questions at this table should be: Wouldn’t it be better to go into passive manage­ment because it’s cheaper?”

Active or passive: costs versus control

For Tim Hay, Portfolio Specialist GEM Strategies at Stewart Investors, active investing is the right path. “Emerging markets have had a tough 15 years, with weak performance and capital outflows. But I think it’s an interesting time to look at this asset class, especi­ally with what’s happening in the US. It won’t take much capital to start moving the needle in terms of asset prices.”

Hay: “We focus on 35 to 45 high-qua­lity companies that align with long-term sustainability goals. If you passively follow an index, you’ll end up with companies and sectors you may not support, like tobacco companies or casinos. You would have been inve­sted in Russia in early 2022 and seen that position fall to zero.”

With a passive index, investors al­so miss out on impact potential, Hay states. They will not be fully invested in the companies that contribute to a sustainable world.

Fred Wouters, Senior Investment Manager at SPMS, the pension fund of Dutch medical specialists, agrees: “Markets in these countries tend to be less efficient, and corporate go­vernance is generally less well-esta­blished. A passive approach may, the­refore, be less suitable.”

Pensioenfonds Horeca & Catering (PH&C) also chooses active strate­gies. CIO Bas van Ooijen: “Our asset managers in this category consider ESG factors, including environmental impact and corporate governance. Their approach must be in full align­ment with PH&C’s ESG policy, so you have to blend in beliefs – your own be­liefs and the active managers’ beliefs. That can be challenging.”

There are a lot of active managers who still have a value tilt toward emerging markets or invest heavily in energy utility companies, says Van Ooijen. “That doesn’t align with our values. We do not invest in the fossil fuel sector and exclude state-owned enterprises that are more than 50% owned by countries on our exclusion list, such as China and Saudi Arabia. These active choices have a me­aningful impact on portfolios.”

Beating the benchmark

Van der Put agrees that active ma­nagers can provide deeper insights and apply them effectively. But ac­tive management also comes with higher costs, which need to be justi­fied by performance. “As I said, only a few managers manage to generate outperformance. Beating the bench­mark is challenging.”

The higher fees of active manage­ment should pay off, states Van der Put. “This will become more impor­tant under the new pension contract, where costs and performance will be­come more visible.”

Since the performance of emerging markets equity over the last few years was rather disappointing, Van der Put understands how this can lead pen­sion funds to the question of how much they want to stay invested he­re. “Especially since there is an alter­native. They could consider owning developed market companies with exposure to emerging markets.”

ESG investors who avoid certain countries, state-owned enterprises, and less ESG-oriented companies can expect longer periods of under­performing the broader market, ar­gues Van Ooijen. “These periods should not last too long. In our evalua­tion framework, we look at three-year performance, if possible, longer.”

Participants may react negatively to underperformance, warns Reinout van Tuyll, Investment Strategist at Achmea Investment Management. “We still believe EM adds valuable di­versification, but people will compare the costs with the performance.”

Hay counters: “You have to take a long-term view. If you look at our stra­tegies over ten years, we’ve outper­formed 96% of the time. I think people are willing to pay active fees for ma­nagers who generate alpha.” Hay also believes competition from custom in­dices will bring costs down.

Custom benchmarks with strategic filters

To balance ESG integration and cost-efficiency, some funds turn to hy­brid approaches, using custom bench­marks with ESG filters. Van Tuyll descri­bes the method at Achmea Investment Management: “We invest passively in a screened EM universe, excluding coun­tries and companies with weak gover­nance. We then optimize the portfolio for carbon reduction.”

Achmea IM may exclude countries based on three factors: human rights, corruption, and labor rights. “We sco­re those, using several data providers, through an internal system, creating a threshold. We exclude countries be­low that threshold. In that sense, it is an active strategy, but one that we manage passively,” says Van Tuyll.

Van Tuyll clarifies that the exclusi­on primarily pertains to government debt and companies that are more than 50% state-owned. “So, we don’t exclude all stocks in a country. Within this framework, we still engage with companies, especially those that are incompatible with our carbon reducti­on strategy because, as an owner, we can influence those companies.”

Hay points out a challenge with tailor-made ESG indices: “You still end up with quite a broad spectrum of a very diversified, maybe overly diversi­fied portfolio. Additionally, passive in­dices are backward-looking. You can screen out companies and govern­ments that may not have done very well in the past, but will never catch the governance blow-up of next week.”

It’s all about the right data

Tim Verheyden, Head of Sustainability Public Markets at Goldman Sachs Asset Management, sees the data scarcity in emerging markets as a strong case for active strategies. He warns that ESG ratings by third par­ties, which can show considerable dif­ferences for the same company, are not always reliable.

Additionally, data providers often measure ESG with the same yard­stick as in developed markets, which may create unfair outcomes, according to Verheyden. “The stan­dards used are often designed for large firms in developed markets. Small EM companies automatical­ly score lower and can be heavily penalised in off-the-shelf ratings from third-party providers.”

For Verheyden, sustainable EM inves­ting requires investors to roll up their sleeves: “You benefit from having your own proprietary views on what a sus­tainable company looks like and enga­ging directly with these companies.”

Wouters is also hesitant about pas­sive ESG benchmarks in emerging market equities, given the low corre­lation between ESG ratings from diffe­rent providers and the high level of ra­ting instability. He shares a cautionary tale about exclusion lists that kept changing every year at a former em­ployer. “Excluding countries and com­panies for labor violations led to he­avy portfolio turnover annually. That’s not ideal for long-term investors.”

Labor rights concerns don’t lead to exclusions at SPMS, Wouters explains: “We also refrain from integrating biodi­versity, from the viewpoint of our exclu­sion policy. Data is still very limited and in its infancy. Within these domains, we so far use engagement, until data and methods improve. We tend to focus on climate, in particular on CO2 reduction, since the data is more prevalent, and on good corporate governance.

Wouters also adds a practical no­te: “Our participants support CO2 re­duction but give less priority to labor rights. That shapes our policy. You can’t do everything at once, so it’s bet­ter to listen to the people whose pen­sions you’re managing.”

Verheyden adds another dimension to this debate: “We need to rethink what ‘active’ really means. The decisi­ons you make in constructing a pas­sive strategy are, in essence, also ac­tive, especially in a world of imperfect data. Pension funds will make diffe­rent decisions.”

How far can you take exclusion?

Excluding an entire country is a big step, seriously limiting the investment universe. Hay: “We focus on individu­al companies, but you have to take a view on the countries as well. The macro will never make an investment case, but it can break an investment case. We’ve never had a stock, as far as I can remember, in Russia. We are not comfortable with state interferen­ce in companies, limiting their ability to generate a profit.”

Hay stresses the importance of own research. Stewart Investors likes to select companies with family owner­ship that treat minority shareholders as equals. “These families are not looking at the next quarter but have a long-term generational view.”

Van der Put shares his experiences at Centraal Beheer APF with speci­fic environmental investment crite­ria. “If we had implemented these, we would have kicked some of the poorest countries in the world out of our investment universe because they’re not so developed in their in­dustries yet. This was a reason not to implement.”

He also points to the debate around excluding fossil fuels. “My first questi­on would be: What is your view on the energy transition? Because an exclu­sion which makes energy prices go sky-high will cause financial problems for many people.”

With ESG investing, investors have to look at motivation, states Verheyden. “Are we integrating data on sustaina­bility because we think it will lead to a smarter investment decision? Or be­cause of values and beliefs? In the lat­ter case, you should be mindful of the impact this has on returns. If you ex­clude fossil fuels, check how this im­pacts risk and returns.”

Verheyden asks whether the vast differences between countries like China, South Korea, or Pakistan justify treating them differently from a local perspective. An important question, agrees Van Tuyll: “Especially concern­ing a giant like China.”

Van Tuyll concludes: “We need to think about how we manage coun­try differences. But at the moment, we haven’t implemented this in our investment strategy. We just view them as one large region. Our main philosophy is to be diversified. But there is indeed a case to tre­at China differently, as well as mo­re developed markets like Taiwan and South Korea.”

The elephant in the room: China

China will raise many alarm bells within a strict ESG framework. Tensions with Taiwan are another red flag. But can investors afford a total exclusion of the country? Wouters: “China con­sists of 40% of the MSCI Emerging Markets Index. If you exclude that, one has to ask: do I want to be invested in emerging markets at all?”

PH&C has China on its exclusion list. This is not a total boycott—only Chinese companies with more than 50% state ownership are excluded from the equi­ty portfolio, explains Van Ooijen.

Achmea Investment Management sticks to the broad emerging markets lands­cape. “If you concentrate too much, you might miss important developments. Last year, over half of the return came from one company. If we had excluded Taiwan out of fear of a conflict with China, we would have missed half the return,” states Investment Strategist Van Tuyll.

Hay paints two sides of China. “Yes, there are state-owned enterprises, but there are also companies with en­ough freedom to make a profit as long as they contribute to national develop­ment goals. At the same time, the gover­nment can change course in one morn­ing, choosing to limit companies or put­ting their weight behind a development, such as transport electrification.”

Still, with 2,500 stocks in China that tra­de over $1 million a day and a market cap of over $500 million, Hay deems only 30 to 40 investable within an ESG framework. Other asset managers re­frain totally from investing in China.

Verheyden sees China as an example of the practice of averaging out en­vironmental and social scores: “From an environmental perspective, China is making massive strides – think of their electric vehicle rollout or solar in­vestments. But on other fronts, things can get more complicated. So, how do you trade these off?”

Outlook

Despite the clear risks – unreliable da­ta, unstable governance, and geopoli­tics – most participants remain com­mitted to EM sustainable equity. Van Tuyll concludes: “Valuations are at­tractive, growth prospects are solid, and these markets bring diversity. But know what you’re getting into.”

Verheyden makes a strong case for climate investing in emerging mar­kets. “We can keep investing in de­veloped markets, but 75% of global emissions come from EM. If we don’t invest there, it can become more challenging to hit climate targets.”

PH&C maintains a neutral, mar­ket-cap-weighted stance, says Van Ooijen. “We hold about 7% in EM, alig­ning roughly with MSCI indices. A drop to 3%, like some funds have done or are doing, feels overly conservative.”

Van Ooijen: “Emerging markets add di­versification to your broad equity port­folio. Yes, ESG data should improve, but it is not perfect in developed markets either. We are challenged, in a way, that emerging markets have been dramati­cally underperforming in recent years.”

Hay concludes: “I remember when US foundations and endowments had around 11% in EM equities, and this is now under 4%, so a lot of capital has been bounced out. A weaker dollar, which seems to be the stated aim of the White House, could see dollar assets re­allocating again to emerging markets.”

As for impact potential, Hay doesn’t believe that anti-ESG sentiment in the US will put the brakes on develop­ments in emerging markets. “These countries experience the actual on-the-ground effects of climate change. They need ESG investing. There’s a ro­le for all of us around this table, I think, to be a partner with those companies that want to make progress.”

Contact us

Ketul Nandani, Head of Institutional Distribution, EMEA Stewart Investors
E-mail: ketul.nandani@stewartinvestors.com
Telephone number:
Office +44 20 7332 9440
Mobile +44 7542 270475

Participants:

→ Tim Hay, Portfolio Specialist GEM Strategies, Stewart Investors

→ Bas van Ooijen, CIO, PH&C

→ Jeroen van der Put, board member Centraal Beheer APF

→ Reinout van Tuyll, Senior investment strategist, Achmea IM

→ Tim Verheyden, Head of Sustainability Public Markets at Goldman Sachs Asset Management

→ Fred Wouters, Senior Investment Manager, SPMS