Economic development is at a crossroads for emerging markets, and the road ahead will need to be paved with environmental, social and governance considerations.

Emerging markets have become the world’s most dynamic growth engines in recent decades, giving rise to an impressive host of new companies, technological innovations and consumer trends.

They are home to around 30 per cent of the firms included in the 2018 Fortune Global 500 – a fourfold increase from seven per cent in 2005, according to research from Cornell University1 – and the International Monetary Fund estimates gross domestic product (GDP) for emerging economies now accounts for 60 per cent of the global total when compared on a purchasing-power-parity basis. This is a 24-percentage point increase over the past 30 years.2 And despite slowing growth amid heightened trade tensions, Standard Chartered expects China to surpass the United States as the world’s largest economy in the next decade, with six other emerging markets in the world’s top 10 economies.3

“The decisions made in emerging markets will have enormous consequences, not only for those nations, but for the entire planet,” said Steve Waygood, chief responsible investment officer at Aviva Investors.

Emerging markets rising

Rapid economic development comes with its own set of environmental, social and governance (ESG) challenges, which are becoming more urgent in emerging markets. Take urbanisation. By 2050, the United Nations predicts around 2.5 billion people will migrate from rural to urban areas, with nearly 90 per cent concentrated in emerging markets. Asia’s emerging markets already lead the world with seven of the top ten megacities, defined as those with more than ten million people: Shanghai, Jakarta, Seoul, Beijing, Guangzhou, Karachi and Delhi. Perhaps not uncoincidentally, the region also has some of the most polluted cities in the world, including New Delhi, India; Dhaka, Bangladesh; Lahore, Pakistan; and Kashgar, China.4

Overcrowding has led to a host of social and governance problems. In China, for example, many migrants who have left the countryside find they are instead trapped in city slums. Labour unrest is rising. And rural migrants are often denied social services in China’s big cities, fostering citizenship inequality.

At the same time, urbanisation has allowed China and other emerging markets to prosper as its workers have more opportunities in higher-productivity jobs, lifting an increasing number of people out of poverty. For governments, urbanisation makes it easier to provide services such as infrastructure, education and healthcare. Economies of scale also help improve efficiency for companies because employee networks make it easier to share knowledge, cooperate on projects and boost competition, according to John West, economist and author of Asian Century… on a Knife-edge: A 360 Degree Analysis of Asia’s Recent Economic Development.

“Emerging markets, particularly those in Asia, have performed well for a number of decades, but they are now at a critical point of economic development,” says West, executive director of Asian Century Institute, an organisation that conducts research and analysis on Asia. “To maintain their attractiveness to foreign investors, things need to change.”

Perhaps nowhere are the fruits of EM growth more clearly reflected than in financial markets. The annualised return of EM equities was 8.68 per cent in US-dollar terms for the MSCI Emerging Markets Index between its launch on 1 January 2001 and 31 May 2019. In comparison, the MSCI World Index, which represents developed economies, returned 4.84 per cent and the MSCI ACWI Index, which combines both developed and emerging markets, returned 4.94 per cent during the same period. When comparing Sharpe ratios, a measure of risk-adjusted returns, the MSCI EM Index at 0.42 comfortably outpaced MSCI ACWI and MSCI World, both of which had a Sharpe ratio of 0.28 during the same period.

However, despite the potential for higher returns, there are risks. Emerging markets outperformed developed markets in the three-year period ended 31 May, again in US-dollar terms, but they lagged over five- and ten-years. They have also exhibited higher volatility, as measured by standard deviations in returns, than developed markets. The annualised standard deviation for the MSCI EM index was 15.58 and 17.42 per cent over five- and ten-years. In comparison, it was 13.37 and 11.49 per cent for MSCI ACWI and 13.18 and 11.40 per cent for MSCI World.

Sustainability unpacked

As much as investors need to understand markets, they also need to understand themselves. To meet their investment targets, it is crucial to balance investment returns against other goals such as risk tolerance. To avoid short-term pitfalls, active risk management combined with a longer time horizon may allow investors to access EMs’ growth trajectory more efficiently. Indeed, many are shifting from a tactical to a more strategic approach when investing in emerging markets. And in doing so, they are aligning their investment processes more closely with ESG considerations, which tend to be more long term.

The growth of ESG integration into the investment process is helping to change corporate behaviour in EM

“The growth of ESG integration into the investment process is helping to change corporate behaviour in EM, and therefore impacting asset valuations,” says Rick Stathers, senior ESG analyst at Aviva Investors. “It’s about creating positive changes and delivering alpha.”

There is some evidence ESG integration can also have a potentially larger impact on risk-adjusted returns in emerging markets than developed markets, as figures 1 and 2 highlight. For emerging markets, the MSCI EM ESG Leaders Index gained 9.12 per cent in the ten-year period ending 31 May, compared to a 5.38 per cent increase for the broader MSCI EM Index. During the same period, performance of the MSCI World and MSCI World ESG Leaders indices are similar, both increasing about 10.5 per cent.

figure 1
figure 2

Behind the numbers

ESG risks may contribute to the higher dispersion existing between EM countries, sectors and companies, and therefore present a potential source of alpha, says Alistair Way, head of emerging market equities at Aviva Investors. First, ESG practices in emerging markets often trail developed markets, with the pace of improvements differing widely. Second, a greater variety of regional constraints and influences also contribute to the different stages of development.

Furthermore, governments usually have a greater role in EM companies, with state-owned companies subject to significant interference in their operations, Way adds. Government control can benefit investors if the company is seen to have competitive advantages such as more favourable financing terms, contract awards or client access. However, their goals and incentives may be less aligned to minority shareholders, with capital allocation decisions overshadowed by political rather than financial motives.

Companies such as Brazilian energy giant Petrobras, in which the state directly and indirectly holds 64 per cent of voting shares and has been embroiled in a prominent corruption scandal, often account for a smaller proportion of ESG indices because of lower ESG scores – in particular governance – compared to fully-public companies.5 In addition, state-run companies tend to operate in sectors that are generally less represented in ESG indices, such as energy and materials – oil and gas in the case of Petrobras.

In a study published by Cambridge Associates comparing the constituents of MSCI EM and MSCI EM ESG indices between July 2013 and June 2016, the consultancy concluded that the MSCI EM ESG Index was heavily underweight state-owned enterprises (SOEs) due to lower ESG scores. Of the largest 40 companies in the parent MSCI EM Index, 13 are SOEs. The EM ESG Leaders Index had no exposure to 11 of the 13 SOEs, and not holding the stocks contributed positively to outperformance.6

“Concerns over SOEs have seemingly been around for so long, one wonders how they could not already be amply discounted by markets,” the report stated. “But the ESG ratings process has clearly been effective in identifying underperforming companies here.”

Similar concerns exist among family-owned companies or those with a relatively small proportion of free float shares. They tend to be under less pressure to adopt best practice on issues like board independence, so are more likely to have lower ESG scores and are less represented in EM ESG indices.

By monitoring and engaging with companies across a wide range of ESG indicators, investors can make better-informed decisions

In the current market environment, stock-specific risk events such as a corporate governance problem may be severely punished by the markets, so ESG considerations become even more important when assessing risks, Way says. By monitoring and engaging with companies across a wide range of ESG indicators, investors can make better informed decisions.

“To generate strong, sustainable investment returns for clients over the medium term, we need to understand what the key company and industry-specific drivers are,” Way says. “ESG is an important part of that.”

GDP versus GDP per capita

The Asian Century Institute’s West believes developing nations are reaching a critical juncture where they face different challenges to become higher value-added economies. Some of these solutions will require ESG improvements.

Moderating growth is coinciding with rising debt levels in emerging markets, including China. Overall GDP may still be growing, but GDP per capita remains far below that of developed nations such as the US, UK, Japan and Germany, as seen in figure 3, below.

figure 3

“Unless there are major new reforms, emerging market countries may continue to be behind developed markets in GDP per capita for a long time,” West says. “That is important because GDP per capita is the amount of goods and services a country produces for each person. This is an indication of productivity improvements, which are reflected in consumption growth. Countries with higher GDP per capita have higher consumption and a higher standard of living.”

Reaching this next level will require emerging countries to address several main challenges:

  • Getting more value out of global value chains (GVCs), which can be accomplished by improving human capital, technology and innovation capacity.
  • Urbanisation’s potential can be enhanced, for example, by tackling some of the related environmental issues such as air, water and soil pollution.
  • Inclusive economic development should include labour rights, gender equality and anti-discrimination measures.
  • Demographic challenges will require social programmes, including education for a booming youth population in countries such as India, Indonesia and the Philippines.
  • Economic crimes such as illegal surveillance, counterfeiting and piracy are damaging emerging markets’ long-term prospects, requiring governance solutions at the corporate, sector, national and international levels.
  • Rising geopolitical risks are undermining global solutions that impact emerging markets, including climate change.
  • Political stability within emerging markets is also important to long-term growth, and more democratic political structures are needed.

“As economies evolve, they need to become more innovative rather than just copying what others have done,” West says. “To do that, people need the freedom to be different, the freedom to make mistakes, and the freedom to come up with new ideas. That’s less possible in the authoritarian political systems of many emerging markets.”

Evolution, not revolution

Active management may help investors benefit from improvements in ESG practices. Several trends are helping them to do so in emerging markets.

Increased scrutiny in the aftermath of major scandals has ushered in governance reforms

First, increased scrutiny in the aftermath of major scandals, such as those involving Brazil’s Petrobras, 1 Malaysia Development Berhad (1MDB) and South Korea’s Samsung Group, ushered in further reforms that strengthen the case for ESG improvements.

In Malaysia, for example, Mahathir Mohamad returned to power on an ambitious corporate reform agenda to prevent a repeat of the 1MDB scandal. Among other policy changes, his administration has introduced transparency rules in public-procurement procedures, anti-graft provisions within public services and stricter requirements to make institutions more independent and accountable.

“Reforms in themselves, however, are not sufficient. They need to be connected to the roles of government, local industry and individual companies,” says Stanley Kwong, ESG analyst at Aviva Investors.

Second, the rising influence of international shareholders is an important driver for ESG developments among EM companies. Those wishing to tap into international capital markets are increasingly scrutinised for their ESG standards, with many global investors placing more emphasis on activism and voting.

As Kwong puts it: “A lot of Malaysian companies are beginning to understand how ESG links to their business values. That’s where engagement can really help them. As they venture out internationally, companies are seeing that ESG can give them a competitive advantage.”

Companies need to ensure their environmental and labour standards are high to be able to tap into the global supply chain

Global consumer and media scrutiny of companies’ supply chains is another significant factor. Companies need to ensure their environmental and labour standards are uniformly high to be able to tap into the global supply chain, particularly in sectors such as electronics and textiles, but also agriculture.

Brazil, for instance, is the world’s top exporter of commodities, including sugar, beef, maize and soybean. Much of this goes to Europe and the US, where stricter standards are increasingly applied across the entire supply chain, says Sora Utzinger, ESG analyst at Aviva Investors. In 2017, the French National Assembly passed the corporate duty of vigilance law. This requires multinational companies to carry out mandatory risk assessments across their supply chain to identify and prevent activities with adverse human rights and environmental impacts.7

Within Brazil, regulatory changes by the administration of recently-elected President Jair Bolsonaro to ease restrictions on clearing rainforest for agribusiness could reverberate across the world. The Amazon generates about 20 per cent of the world’s total oxygen and absorbs as much as one-tenth of global fossil fuel emissions. If between 20 and 25 per cent of the Amazon is destroyed, the impact could push it over a tipping point, at which the damage could be irreversible in eastern, southern and central Amazonia.8 About 16 or 17 per cent of the Amazon has already been destroyed,9 with evidence the rate of deforestation is beginning to rise again, as shown in figure 4. “There is a shift in priorities,” Utzinger says.

figure 4

One example concerns the agency in Brazil tasked with demarcating land for indigenous communities. That responsibility used to sit with the justice ministry but has now been transferred to the agriculture ministry under Bolsonaro. “This represents a weakening of the justice ministry’s mandate, which is a governance issue, and subjects the rights of indigenous tribes to an economic imperative,” Utzinger adds. “If indigenous people are displaced to clear land for logging, cattle or crops, that is a human rights issue. And it’s an environmental problem. The E, the S and the G are all related.”

Companies – and investors – do not have to follow Bolsonaro’s lead. Businesses operating with higher ESG standards may be in a better position to expand their businesses globally, says Jonathan Toub, emerging market equities portfolio manager at Aviva Investors. These also tend to be businesses that may be more financially sustainable in the long term.

“Presidents come and go in Brazil,” Toub says. “Regardless of the political climate, we should be able to find companies that not only adhere to good environmental standards but also good social and corporate governance standards. Better companies will look beyond the minimum.”

Eyes wide open

Regulatory and investor pressures have also helped to raise the bar for corporate ESG disclosures in emerging markets. According to the Sustainable Stock Exchanges Initiative, a United Nations partnership programme working with stock exchanges and securities market regulators to promote responsible investment, 22 of the 38 stock exchanges that have ESG reporting guidance for listed companies are based in emerging markets. Furthermore, six of the 14 countries that have developed stewardship codes since 2014 are in emerging Asia.

As stock markets in emerging markets expand and become more important globally, ESG data generated by companies listed on those exchanges can help investors assess the sustainability of their investments more closely. China’s Alibaba, the biggest rival to online retailer Amazon, is reportedly considering a US$20 billion flotation in Hong Kong instead of the New York Stock Exchange, where it launched its initial public offering in 2014.10

Despite these improvements, data in emerging markets remain inconsistent, meaning engagement can further help investors to benefit from any ESG momentum at the company level. “ESG risk is almost automatically discounted for EM companies,” Way says. “If we can reduce those risks, valuations should be higher.”

Greenwashing is an ongoing concern. Engagement can help investors compare what companies say against what they do

‘Greenwashing’, a general term meaning the practice of making unsubstantiated ESG claims, is an ongoing concern. Engagement can help investors compare what companies say against what they do.

“We’ve seen sustainability reports that are nicely presented but don’t include any of the important, tangible elements such as metrics and measurable targets,” Kwong says. “In some instances, there’s no one accountable for the information in the sustainability report.

“But if companies demonstrate they have really embraced ESG, there’s an opportunity from an investor’s perspective. It is at this early stage that you can truly shape and affect the organisation’s ESG culture,” adds Kwong. 

Malaysia’s Hartalega Holdings, a manufacturer of nitrile gloves used in the medical industry, has outpaced the competition both in its ESG practices and profitability, says Will Ballard, head of emerging market small-cap equities at Aviva Investors. One of the largest manufacturers of high-end disposable nitrile gloves in the world, most of its revenues come from the US and Europe, where there are stricter environmental regulations.

Over the years, Hartalega has consistently invested in best-in-class facilities that meet or exceed environmental standards; reducing its use of natural resources. Its health, safety and environmental performance regularly outpaces peers, and it sets aside four per cent of annual profits to invest in equipment and technology to help protect the environment. The air emission levels of its scrubber towers, for example, are up to 20 times lower than the regulated standards.

“When we analyse such a company, we consider how the industry it operates in is changing and the drivers of that change,” Ballard says. “The result is a potential competitive advantage when standards and regulations change. By understanding these kinds of dynamics, we believe we can improve the return prospects for clients”.


  1. Lourdes Casanova and Anne Miroux, ‘Emerging market multinationals report (EMR) 2018’, Cornell SC Johnson College of Business, 2018.
  2. ‘GDP based on PPP, share of world’, International Monetary Fund, April 2019.
  3. ‘These could be the world’s biggest economies by 2030,’ Bloomberg, 8 January 2019.
  4. ‘2018 World Air Quality Report’, IQAir AirVisual, 2018.
  5. ‘The value of ESG data: early evidence for emerging markets equities’, Cambridge Associates, October 2016.
  6. Ibid.
  7. ‘The French Law on Duty of Care: A Historic Step Towards Making Globalization Work for All,’ Business and Human Rights Journal, Cambridge University, July 2017.
  8. Thomas E. Lovejoy and Carlos Nobre, ‘Amazon Tipping Point,’ Science Advances published by the American Association for the Advancement of Science, 21 February 2018.
  9. ‘Amazon deforestation is close to tipping point,’ published by Science X Network, 20 March 2018.
  10. ‘Alibaba Weighs Raising $20 Billion Through A Second Listing,’ Bloomberg, 27 May 2019.

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