Emerging-market ESG ETFs: what investors need to know

Tempted investors must understand that they will be making active bets, writes Briegel Leitao.

The momentum gained by environmental, social and governance (ESG) factors and socially responsible investing has been a key element in the global ETF landscape’s strong growth over the past few years. Investors looking to make a socially conscious allocation now have a wide range of ETF options.

Emerging markets have tended to lag developed market peers on ESG metrics. Emerging market nations tend to have large, fast-growing populations, so they are often among the world’s worst polluters. On the corporate governance front, while larger emerging market firms have improved their financial and operational disclosure, challenges remain.

For investors looking to avoid the worst offenders, ESG ETFs are a cost-effective solution. They typically track indices that use best-in-class ESG selection approaches designed to exclude laggards while maintaining similar sector weights to parent indices.

ESG-screened indices in developed markets, owing to generally better standards of practice, tend to produce similar portfolios to their non-ESG counterparts and deliver low tracking error in exchange for improved ESG profiles. In emerging markets, however, where the opportunity set is vast and diverse, passive ESG strategies often end up taking active bets at the country and stock level.

Investors should examine ESG emerging markets portfolios carefully, as their better overall ESG profile can mean sacrificing key market exposures.

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Notable weightings

Morningstar rates four of the largest ESG emerging market equity ETFs listed on the London Stock Exchange (see table). Two of these track variants of the MSCI SRI index, which targets the top 25% of firms in the MSCI EM universe based on their ESG ratings. This results in a heavy underweight to China (9% versus 41% for MSCI EM), accompanied by overweights to India and South Africa. Note too the exclusion at the stock level of Alibaba, Tencent, and Samsung Electronics. A 5% cap on individual names ensures a sufficiently diversified portfolio.

The iShares MSCI Emerging Markets SRI and UBS MSCI Emerging Markets SRI ETFs carry a high Morningstar sustainability rating of five globes. The rating measures how well the underlying companies manage their ESG risks and opportunities compared with holdings of similar funds.

The Xtrackers ESG MSCI Emerging Markets ETF’s more lenient selection includes firms with the strongest ESG credentials among the top 50% of emerging market equities. Single stocks are uncapped, so the strategy ends up steeply overweight to Alibaba and Tencent, bloating the fund’s allocation to China. Collectively, these two stocks comprise 30% of the allocation, exposing investors to stock concentration risk.

The iShares MSCI Emerging Markets IMI ESG Screened ETF excludes firms in controversial industries such as armaments and tobacco – just 150 stocks out of the 3,050-plus holdings in the parent index, accounting for less than 10% of the total index market capitalisation. With such a small exclusion, the ESG screen has little impact on the fund’s sustainability profile. The fund gets an average Morningstar sustainability rating of three globes and shows no improvement compared with its non-ESG ETF counterpart.

Investors looking to invest in emerging market ETFs need to be at ease making active bets, principally on their weighting to China, and to assess the merits of excluding the emerging market growth stalwart.

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Briegel Leitao is associate analyst, manager research, passive strategies at Morningstar.