Emerging Markets  

EM funds avoiding China produce 'most sustainable' returns

EM funds avoiding China produce 'most sustainable' returns

Emerging market equity funds with a higher active share and lower exposure to Chinese stocks are more likely to produce sustainable returns, according to research from fund ratings agency Morningstar.

The firm has partnered with stock-rater Sustainalytics to study investment funds’ overall sustainability, partly based on the environment, social and governance credibility of the holdings, and also their ability to manage corporate risks and opportunities.

Its research found that the highest-rated funds in the emerging markets sector had an average active share of 85.4 per cent. This compared with the lowest-rated sustainable funds which had an average active share of 76.8 per cent.

Morningstar said this further correlated to the funds’ exposure to Chinese entities. The country’s stocks were scored poorly by Sustainalytics, while Morningstar further rated China as the worst region for governance due to its index’s tilt towards government-controlled companies.

The 18 funds in Morningstar’s emerging markets sector which were rated highly in terms of sustainability had an average China weighting of 9.8 per cent. This compared with 24 per cent for the 21 lowest-rated funds.

Morningstar head of sustainability Steven Smit said there were significant differences between emerging market countries in terms of the number of sustainably-rated stocks.

“We know companies in some countries on average score considerably lower than others. Within emerging markets there are some big differences. The exposure emerging market funds have to China broadly determines their overall sustainability score.

“If they invest more in China, their score tends to go down,” he said.

Mr Smit said the correlation to active share showed that the more sustainable investment funds were those that deviated away from the benchmark, although he admitted the China effect was also likely a factor given the country’s weighting in the index.

He added: “It might not be a conscious choice; they may find other regions more attractive and become more sustainable when that’s not the intention. In these emerging markets, there is a lot of difference in scores. If you leave out Russia and China, you would do better.”

While Morningstar has not yet tested whether its sustainable funds typically produce stronger returns, eight of the 18 highly rated portfolios had been attributed a bronze, silver or gold rating from the firm. No low-rated funds achieving this qualitative measure.

Likewise, the average size of a highly rated sustainable fund was £1.2bn, compared with £136m for low-rated funds.

Mr Smit added: “If you compare sustainability and Morningstar ratings – there are a lot of bronze, silver and gold funds that also score very high in sustainability. Teams with high Morningstar ratings and sustainability sometimes go hand in hand.”

However, this link was not seen in other sectors. In the UK large cap grouping, the lowest-rated funds had an average size almost twice that of the highest-rated. Similarly, of the 16 low-rated funds, five had bronze or silver Morningstar ratings compared with only one highly rated fund.