Many investors are overlooking the returns boost they can get by focusing on environment, social and governance (ESG) factors in emerging-market equity strategies, according to new research. However, the same benefits are not visible for developed-market stocks.

The MSCI Emerging Markets ESG Index beat its parent MSCI EM Index by a cumulative 12% in the three years since its launch in June 2016, on a total-return dollar basis. Just over half of that additional performance was attributable to ESG factors alone, says US-based investment consultancy Cambridge Associates. Moreover, analysis of all the EM ESG data since January 2007 broadly supports this finding, said the firm.

Of the 367 basis points of annualised outperformance achieved by the MSCI Emerging Markets ESG Index, 199 basis points were attributable to specific ESG factors after accounting for the contribution of other factors such as country, currency, sector and style (see graph below).

“This is particularly important because ESG factors typically tilt towards equity styles that have recently outperformed – for example, quality-focused growth,” said Chris Varco, senior investment director for mission-related investing at Cambridge Associates and author of the report.

“Our study therefore refutes the assertion that ESG factors are just proxies for other things, rather than valuable investment tools in their own right.”

The findings will be heartening for the growing number of institutional investors in Asia looking to incorporate ESG approaches or strategies in their portfolios. Just this week Taiwan's Bureau of Labor Funds said it would outsource its first global ESG mandate to the tune of $2.4 billion. And organisations such as Japan's Government Pension Investment Fund and New Zealand Superannuation Fund are increasingly ramping up their ESG focus. 

Yet many investors are, in effect, ignoring the stream of new data that has become available over the past five years, noted Varco. ESG data should be a key tool for investors in emerging markets, he said.

EM equity investors often focus on commodity prices, currency and macroeconomic factors, as well as domestic consumption trends, added Varco, and tend to underestimate the value of widely available information on the ESG strength of companies.

He also attributed the performance of the MSCI EM ESG Index to the avoidance of state-owned enterprises (SOEs), which feature prominently in the parent index.

“SOEs are influenced by interests beyond generating profits for shareholders, which can negatively impact operational aspects of the business,” Varco said. The same accusation has been levelled at family-owned businesses, which are also common in emerging markets, he added.

A different story in DMs

While ESG factors have a clear value for EM investors, the benefits are less obvious for developed-market portfolios. In the six years since its inception, the MSCI World ESG Index slightly underperformed the MSCI World Index, its parent index, by 10bp.

In fact, ESG factors negatively affected the performance of the MSCI World Index, detracting an annualised 54bp from the excess return.

The key observation, said Cambridge, is that ESG-based stock selection added value outside the US, but struggled with stock selection in this market.

Explaining this, Varco noted that some mega-cap US companies that performed well in recent years were excluded from the ESG index. For example, four stocks – Amazon, Apple, Facebook and Home Depot – were completely excluded from the ESG index during the entire three-year period.

Cambridge Associates said ESG data could be valuable in developed markets if used in a nuanced way. Many active managers integrating ESG analysis alongside financial analysis have outperformed the MSCI World Index in recent years, noted the firm.