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Investment professionals are proving that  responsible and ethical investing in emerging markets (EM) can go hand-in-hand with superior returns. At the same time, doing so may protect the environment and produce economic growth that is sustainable over the long term.

The success of investing through environmental, social and governance factors (ESG) is in the numbers. Over the last decade, the MSCI Emerging Markets ESG Leaders Index, which tracks companies with high performance in ESG metrics relative to their peers, outshone the broader MSCI Emerging Markets Index, with a 14.5 percent annualised returns versus 10.7 percent, according to data from indexing firm MSCI.

Over 10 years, the additional 3.8 percentage points can make a difference in a portfolio. One million pounds invested in the "ESG leaders" portfolio would have grown to £2.8 million in the recent decade, versus £2 million for the non-ESG portfolio.

"Increasingly, people are starting to appreciate that adding ESG is a source of alpha," says Phil Langham, head of EM equities at RBC Global Asset Management (GAM) in London. Alpha refers to the additional returns from selecting individual stocks relative to investing in broad indexes.

Langham says  RBC GAM has used such metrics for almost a decade, with results outperforming by up to five percentage points each year. In 2010 for instance the ESG EM leaders portfolio returned 25.9 percent versus 19.2 percent for the broader EM portfolio.

"Companies that pay attention to ESG have a real culture of excellence," says Langham. "They have much more engaged employees who are much more productive."

Environmental action

So far, the majority of EM economies such as Brazil, Russia, India and China (BRIC), have replicated developed markets by fueling their economic growth with carbon-based energy, like oil and coal.

The problem is that such growth is no longer considered sustainable due to the destructive nature of fossil fuels on the environment. That impact includes flooding in places such as Bangladesh and potential water shortages in other locales, says David Storm, associate, global manager research at RBC Wealth Management in London. Many poor economies don't have the resources to deal with such problems, so prevention of future problems is vital.

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Some governments are tackling the problem head-on, including the leaders of the second largest economy in the world. "China has been the most proactive country," says Storm. "In 2007 it introduced a concept of 'ecological civilisation' and now that idea has a central position in the economic growth strategy." Specifically, the leaders emphasised public transport and green buildings as a way to cut pollution. And China is now the largest market for electric vehicles.

Beijing and Shanghai have suffered for years under clouds of smog. According to a United Nations report, 92 percent of Asia and the Pacific's population are exposed to levels of air pollution that pose a significant risk to their health. The report details how carbon dioxide emissions could be reduced by almost 20 percent in 2030, if 25 measures are implemented.

Other countries are using so-called "green financing" to fuel sustainable economic growth, including Mexico. "Mexico City airport issued a green bond two years ago to fund solar energy equipment for its airport," says Storm. Such bonds are dedicated to financing environmentally friendly projects, which are typically audited for compliance with the stated use of the funds.

The market for these green securities has grown exponentially over the past few years. In 2018 a total of 320 issuers sold green bonds with a face value of US$167 billion (£219 billion), up from less than $50 billion in 2015, according to data from the Climate Bonds Initiative.

Tackling governance

Governance refers to how companies and other institutions are managed. In this respect, emerging markets are different from developed markets and that can be an advantage for investors who know what to look for.

"What you see in emerging markets are many more state-owned enterprises and lots of family-owned or controlled companies," says Langham. Both may be beneficial, but in different ways.

One potential advantage of family-controlled businesses is that managers and leaders they employ tend to stay in their positions for extended periods of time.

When executives take a long-term view of managing the company, profits may be more stable or sustainable; both are things investors appreciate.

State involvement in a company may also be helpful to companies because red-tape can sometimes quickly be eliminated or streamlined when a government has an ownership stake in the firm.

This helps reduce costs and boost profits for companies that benefit in such a manner from partial government ownership.

Addressing social issues

Social initiatives are integral to the emerging market investment thesis.

Health care is one such key area and has the potential to improve the lives of EM citizens and also offers opportunities to investors.

Analysts, such as Langham, expect health spending in EM to grow disproportionately faster than their economies as these countries become richer. Currently developed markets, such as the U.S. and UK spend more than double the percentage of GDP on health care than EM countries such as China, according to World Bank data.

That difference in spending is likely to decrease. For instance, as China grows its economy the dollars spent on health care will increase even faster. When that happens, some health care providers could see big boosts in profits and investors could see gains.

"In general, the thesis is a catch-up thesis," says Graham Stock, EM senior sovereign strategist at BlueBay Asset Management 1 in London. "We should expect emerging markets to grow faster because they're starting from a lower level of GDP per head and there's a catchup as the middle class grows."

Of course, that catchup idea applies not just to health care but also to access to education and quality sanitation, which are key social issues in many EM.

Strategies for implementing United Nations goals

All three ESG factors fit well within the United Nations Sustainable Development Goals (SDG), which were adopted by member states in 2015. They outline 17 targets economies should strive to achieve. One such goal is to provide "access to affordable, reliable, sustainable, modern energy". While the list of goals is extensive, it also provides a useful framework through which business leaders can evaluate their own strategies.

"It's like a road map to development that is sustainable, and it means economically you'll be sustainable and successful," says My-Linh Ngo head of ESG Investment Risk, at BlueBay in London. "That makes intuitive sense. Those companies don't exist in a vacuum. If they have good relations internally and externally with their stakeholders, they're more likely to be successful financially."

1BlueBay Asset Management is a wholly owned subsidiary of Royal Bank of Canada with full investment autonomy and operational independence.