Home / Proceed with caution in emerging markets

Investing in emerging markets is a bit like making a soufflé: it's a courageous undertaking fraught with the risk of things not working out as hoped. EM economies may be buffeted by political strife, currency crises, and other upheavals, leaving investors a bit deflated.

Investing in emerging markets is a bit like making a soufflé: it’s a courageous undertaking fraught with the risk of things not working out as hoped. EM economies may be buffeted by political strife, currency crises, and other upheavals, leaving investors a bit deflated.

On the other hand, if conditions are right, the potential rewards are high. Emerging markets can be a source of rapid and robust growth, providing diversification and maybe – just maybe – puffing up overall portfolio returns.

Yet at the same time, many have rightly observed that companies in the emerging markets may be operating under very different standards than their counterparts in developed markets. From labour and product safety practices to environmental safeguards to accounting requirements to shareholder rights, EM public companies don’t always encounter the same constraints that US and other public companies face.

Depending on your outlook, this could make investing in emerging markets even more attractive from a return perspective, or even more concerning from a risk perspective. Compounding this issue is the high degree of family or state control over a given public company in many EM countries, limiting outside shareholders’ ability to influence a company’s behaviour.

What does this mean for ESG investors who want to gain exposure to EM stocks? Can they practice active ownership to help encourage better business practices? If not, can they at the very least use screens to safeguard their portfolios from investing in certain business activities or behaviours?

Active ownership in emerging markets: a steeper hill to climb

Even with respect to public companies in developed markets, for investors who want to exercise their shareholder rights the watchword is patience. It can take a long time for engagement to play out or for resolutions to gain traction at the ballot box. This is even more so the case in emerging markets.

As I mentioned above, in EM countries, concentrated family or state ownership can effectively silence shareholders’ voices. But the challenges don’t necessarily stop at ownership concentration; shareholder rights in some countries might be abridged by regulatory or process impediments.

A common obstacle to voting is share blocking, a situation in which an investor who casts a vote is precluded from trading a security for some period of time around the annual meeting. Another hurdle to voting is power of attorney requirements, which force investors to provide their custodian with burdensome legal paperwork to prove they’re allowed to vote. What’s more, proxy materials are typically in a foreign language (if not in a different alphabet) and may not even be available in advance of the deadline.

For many EM investors, voting is simply not worth the hassle.

The result? EM investors seeking to effect change through active ownership are limited in what they can do.

ESG screens in emerging markets: a dearth of reliable data

So if you’re not prepared to push the active ownership boulder up the hill, what about the other approach – making sure your EM portfolio contains only those companies whose business practices or involvement you feel comfortable with? Here again, with EM companies the process can be a bit more challenging than it is with developed market companies.

The reason is that good screens rely on good data. And while information on EM companies’ business involvement – in other words, where their revenue comes from – is generally available via their financial statements, other kinds of data depend on discretionary disclosures.

For example, what kinds of labour standards does a given company observe? Are metrics available for the company’s carbon emissions?

To be fair, accurate data of this nature is difficult to obtain even for companies with good disclosure. Carbon emissions and natural resource management in particular are hard to estimate even when companies want to.

But for countries with different local regulatory and operating norms, this data can be even harder to come by. All of which is to say that while there are some screening techniques that claim to capture ESG data for EM companies, investors should understand the limitations of the data and ensure their process for investing in emerging markets can withstand this uncertainty.

The bottom line

ESG investing relies on having good information about public companies and a well-defined process to communicate with management. Given this, we’d counsel EM investors to manage their expectations in this space and consider a wider range of tools, including a disciplined approach to diversification and rebalancing, to help mitigate risk or improve returns.

EM countries continue to evolve, and some have made solid progress in recent years with regard to corporate governance. But when it comes to ESG investing in emerging markets, the only certainty seems to be uncertainty. 

Jennifer Sireklove, CFA, is managing director, investment strategy at Parametric