(Bloomberg) -- A lack of reliable ESG data in emerging markets is proving a boon for some of the heavyweights of global finance.
Federated Hermes Ltd. is among investment firms that have spent the past year building its ESG exposure to emerging markets, where it says “artificially low” environmental, social and governance ratings have created openings for investors willing to do their own research.
The “mainstream” ESG ratings firms often give emerging-market stocks a lower ranking because of fewer disclosures relative to companies listed in the developed markets, said Martin Todd, a portfolio manager at Federated Hermes.
That’s created “some really interesting valuation opportunities,” he said in an interview. “Emerging markets overall have come back to a really attractive valuation and it’s a region where we see a lot of ESG names overlooked by investors.”
Federated Hermes is investing in banks in under-developed markets, particularly those that seek to include vulnerable individuals who wouldn’t normally have access to a bank account. Getting a foot in now is key, “as these economies develop and as banks develop and use more technology, more and more people enter the financial ecosystem,” Todd said.
It’s long been an ESG-investing mantra that asset managers can’t get hold of the information they need to make informed decisions. Nowhere is that truer than in emerging markets, where ESG regulations are less advanced than in Europe and the US, and ratings aren’t as well-established.
ESG ratings for emerging-market companies are “artificially low because of a lack of disclosure rather than because of any particular concerns” around environmental, social or governance factors, Todd said. “We’re not seeing all the details reflected in ESG scores,” he said.
At MSCI Inc., which is one of the world’s biggest providers of ESG ratings, companies in emerging markets have generally “tended to have lower ESG ratings than their developed-market-domiciled industry peers in our global basis of comparison,” Meggin Thwing Eastman, the firm’s managing director for ESG and climate research, said in an emailed comment.
She also warned against painting “all emerging markets with the same brush, as we do see variations.”
A spokesperson for Sustainalytics, the ESG ratings provider owned by Morningstar Inc., said its research team is “structured by sectors enabling material ESG risks to be compared across companies.” The company hasn’t “conducted any recent research to determine how emerging-market companies perform vis-a-vis developed market companies.”
(Bloomberg News parent Bloomberg LP also provides ESG ratings.)
Katerina Kosmopoulou, a partner at investment firm J. Stern & Co., said companies in emerging markets are “often a few steps behind in terms of ESG practices and disclosures versus their developed market peers.” And governance-related issues are “particularly important in emerging markets,” she said.
ESG investors spent much of 2022 treating emerging markets with caution, after Russia’s invasion of Ukraine triggered an industrywide rethink. Fund managers looking for climate-transition assets in developing markets suddenly found they’d exposed themselves to potentially value-destroying social and governance issues, often undetected by ratings until it was too late.
Some investors have reacted by developing their own tools to protect their portfolios from risks often associated with emerging markets. Dutch asset manager Van Lanschot Kempen NV said earlier this year it’s created a test that includes a national corruption score, resulting in a blacklist that encompassed assets from China.
In emerging markets, “understanding the social dimension of transition is actually more important than the environmental side because poverty reduction and the right to develop are usually the highest priorities,” Nathan Fabian, chief responsible investment officer at the United Nations-backed Principles for Responsible Investing, said in an interview.
For investors, that creates an extra layer of risk that’s put some off, but is attracting those with the resources to dig deeper.
Data disclosure “across the board is pretty challenged” in emerging markets, compared with the developed world, “and especially on some of the more nuanced environmental and social-related issues,” said Luke Barrs, managing director and global head of fundamental equity client portfolio management at Goldman Sachs Asset Management. And that’s why it’s possible to find ways to beat the market; it’s an “alpha opportunity,” he said.
Barrs, who in the past has spoken of the “huge subjectivity” of ESG scores, said GSAM’s approach is to “hunt a little bit harder” to find information. It’s about having “the right relationships with management teams” and asking “the right questions to get that insight,” he said.
ESG rating systems remain “highly problematic,” said Teresa Barger, co-founder and chief executive officer at investment firm Cartica Management LLC in Washington. But for those willing to put in the work, “there’s so much opportunity in emerging markets.”
And companies that get funds from ESG investors can “lower their cost of capital and make them more valuable,” she said.
(Adds reference to corruption risks in 13th paragrph.)
©2022 Bloomberg L.P.
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