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Why ESG Emerging Market ETFs Have Underperformed

Newly launched ESG emerging market ETFs have been outperformed by their market-cap weighted counterparts, what has caused this performance divergence?

Emma Wall 18 May, 2017 | 12:00AM

 

 

 

Emma Wall: Hello, and welcome to the Morningstar series, "Ask the Expert." I'm Emma Wall and I'm joined today by Monika Dutt, Passive Fund Analyst for Morningstar.

Hello, Monika.

Monika Dutt: Hi.

Wall: So, a lot of people believe and it may be a misconception that when constructing a portfolio, you can choose between performance and sustainability, but you cannot have both. Does the evidence stack up, in your area of specialty, which is emerging markets?

Dutt: Socially-responsible emerging market ETFs, or otherwise known as SRI funds, have recently been launched in the past year or two. So, we don't actually have a lot of performance history to go by. But what we can say is that while these strategies are passive, they follow an index, they take very large active bets in their country allocation away from market cap-weighted funds that track the MSCI Emerging Markets Index.

So, it is likely that this country allocation will contribute to performance moving forward. And this a very active deviation away. So, for example, China, which is the largest difference, while it has – it represents 26% of the MSCI Emerging Markets Index, it only represents 3% to 4% in socially-responsible emerging markets ETFs. Now, whether that has played in favor is obviously questionable, because China is the second largest economy in the world and most investors with global portfolios may want to allocate more towards China than 3% to 4%.

Wall: You say that we only have one year's data to go on, but based on that one year which have done better? The sort of plain vanilla emerging market index funds or these ESG SRI emerging markets ETFs?

Dutt: It's been the MSCI Emerging Markets tracking funds, because if you take a look at some of the other overweights, for example, South Africa was overweight, South Africa specifically does better in ESG risks, that currency has depreciated by 20% to 30% during the past three years because of the commodity crisis. Meanwhile, the Chinese currency has soft pegged to the dollar, so it follows the exchange rate fluctuations along with the dollar. So, it hasn't been as affected by a rising dollar.

Wall: Having a look at the underlying holdings then, taking aside the large sector weights, which have come with this SRI screen, how have those more sustainable companies done? Have the underlying companies, at least, had positive performance?

Dutt: Yes. When we look at the attribution, the actual stock selection has been positive and it has worked. It's more the country allocations that have not played in favor for these ones.

Wall: These are, as you mentioned, very new ETFs. Is the idea that in time this country breakdown will shift as hopefully more companies across the emerging market universe prioritize ESG issues?

Dutt: Absolutely. That is the whole point of ESG investing is hopefully that it will reward the companies that perform well and it will raise the market standard overall.

Wall: But in the meantime, investors should be careful that they know exactly what they are buying when they are buying one of these ETFs and have a look at what's under the bonnet in terms of the country allocations?

Dutt: Exactly. They have to make a trade-off between their China allocation and their ESG screens.

Wall: Monika, thank you very much.

Dutt: Thank you.

Wall: This is Emma Wall for Morningstar. Thank you for watching.

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About Author Emma Wall

Emma Wall  is Senior Editor for Morningstar.co.uk