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ESG as an alpha driver in emerging markets

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ESG considerations are also emerging strongly in emerging markets portfolios. Many investors want to contribute to change in countries that often still have a long way to go. This process of change can also be one of the drivers of financial outperformance, say Basak Yavuz and Kay Haigh, portfolio managers at Goldman Sachs Asset Management.

The application of ESG criteria (Environment, Social and Governance) in emerging markets is more complex than in more developed markets. This is primarily due to the scarcity of good and reliable data, says Basak Yavuz, manager of emerging markets equity portfolios at Goldman Sachs Asset Management. "There is a lot less transparency than in developed markets. This makes it important to have expertise in local markets, to be able to distinguish the winners from the losers, to find those companies that actually apply ESG criteria."

The challenge of data scarcity is also an opportunity, Yavuz argues. "If you do your job well, you can stay ahead of the competition and generate outperformance for investors. ESG in emerging markets remains in constant flux." She points out that on the equity side alone, Goldman Sachs Asset Management has 25 analysts working in this area, with an average of 17 years of experience.

ESG and government bonds

The differences in ESG scores between countries and companies are large. This divergence also makes it possible to generate outperformance with strict ESG criteria, says Kay Haigh, manager of fixed income portfolios in emerging markets at Goldman Sachs Asset Management. "In the case of government bonds, this seems a little more difficult than in the case of individual companies and corporate bonds, but here, too, you have many instruments. For example, we look at the legal system of a country, the independence of its central bank, income distribution and access to the labour market. We also look at social unrest. These are all important variables that help us generate alpha," says Haigh.

The main issue, according to Haigh, is momentum. "Many ESG scores are static and are retrospective. We are therefore looking not so much at a country's absolute ESG score, but at its improvement. This provides upward potential in terms of return, but it is also an opportunity to stimulate the sustainable or social development that you want as an investor. This does require that you also have the ability carry out a forward-looking analysis for countries."

“Also, for some companies, the absolute level of the score might be less important than the momentum, confirms Yavuz. She states that in emerging markets there are now many companies with excellent ESG score. "But that is reflected in the valuation. A company with good and improving ESG credentials offers more potential for performance and you want to be in those companies", says Yavuz. “

According to her, engagement plays an important role here. "Companies like to engage with us because we have a lot of ESG expertise, thanks in part to our experience in developed markets. We do want to see a path of improvement, visible through milestones and actual investments, for example. Otherwise, we will withdraw," Yavuz says.

Dynamic risk management

Emerging markets offer investors the opportunity to invest in economies that are growing relatively quickly. They take the higher volatility for granted. ESG is not only a way of generating outperformance, but can also be a good way of limiting risks. After all, poor governance, underpayment of staff or environmental pollution are ultimately things that can weigh heavily on a company's results in the long term. The exclusion policy ensures that shares and bonds with a very poor ESG score are not included in the portfolios.

According to Haigh, it is also important to be ahead of the game by estimating where the next wave of volatility in the markets will come from. Good diversification is equally important. "With government bonds, we look beyond the distribution of around 80 countries, but have created a diversified portfolio where the risk does not depend solely on the country distribution. For example, we make classifications according to the state of the fiscal economy, the sensitivity to commodity prices and the sensitivity to world trade. After all, you don't want to have too much exposure to one specific risk factor."

Covid has firmly expanded the number of relevant risk factors, Haigh points out. "Factors we didn't look at much before became important very quickly. Think of tourism, healthcare and capital flows of emigrants to their country of origin." At the same time, the pandemic gave new impetus to ESG, Yavuz argues. "It taught people that we do not have complete control, but that we can improve things. For example, the lockdown made clear that we can indeed improve air and water quality."

Keep up to date with what’s happening in Emerging Markets with the latest insights from Goldman Sachs Asset Management.

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