The ESG screen that EM investors need

A key factor in responsible investing is critical in getting the best from developing-market companies

The ESG screen that EM investors need

While ESG criteria are typically used to help investors apply their values to their portfolios, a growing body of evidence suggests that such factors can help people achieve better returns. That may also apply in the case of emerging markets, particularly when it comes to avoiding state-owned enterprises (SOEs).

“The key issue is to whom the company answers: shareholders or government stakeholders,” said Alejandro Saltiel, CFA and quantitative research analyst at WisdomTree, in a recent note. “Problems arise for investors when [their] interests are not aligned and possibly affect their profitability and future returns.”

To examine the impact of excluding SOEs from emerging-market investments, WisdomTree used securities from the MSCI Emerging Markets Index to construct broad market capitalization-weighted portfolios of state-owned and non-state-owned EM companies. Firms with more than 20% of their shares owned by government entities were considered SOEs.

“Intuition tells us that if shareholder returns and fundamentals such as return on equity (ROE) are not a company’s top priority, this should be reflected in decreased returns and greater risk,” Saltiel said.

Looking at FactSet performance data from 2007 to 2017, the firm found a cumulative performance difference of more than 60 percentage points between non-SOEs and SOEs, with SOEs having higher returns and lower volatility. The most recent calendar year saw non-SOEs contributing 85% of the MSCI EM Index’s return despite having a 75% weight.

Focusing on quality as shown through ROE, Saltiel added, data showed that non-SOEs had higher returns on equity compared to SOEs. This is consistent with the theory that SOE management practices that do not favour shareholders’ interests would result in “lower quality” or “less efficient” fundamental metrics.

“Investing in companies that have shareholder interests as a top priority has proven to be a way to tap into quality, which could lead to potentially higher expected returns,” Saltiel concluded.