Better A Way To Emerging Markets Virtue

When it comes to the environmental, social and governance (ESG) investing phenomenon, many exchange traded funds in this universe are heavy on companies that excel at environmental stewardship, but many of those same firms may be lacking when it comes to the “S” and “G” in ESG.

Not fulfilling all of the objectives of ESG investing is something investors need to be aware with international strategies as well, but there are ways to improve that outlook, even with emerging markets funds.

What Happened

At first glance, the WisdomTree Emerging Markets ex-State-Owned Enterprises Fund XSOE doesn't appear to be an ESG fund, but upon closer examination, XSOE has some credibility as a virtuous investment.

In many large developing economies, energy companies are state-run enterprises, so by excluding state-owned enterprises (SOEs), XSOE gets decent marks on the environmental front. The fund allocates just 6.21 percent of its weight to the energy sector, but where XSOE excels is in governance, an oft-overlooked part of the broader ESG equation.

“There is a phenomenon in emerging markets (EM) of government actors investing alongside other investors in publicly traded equities,” said WisdomTree in a recent note.

“The key issue is to whom the company answers: shareholders or government stakeholders. In our view, companies with meaningful government ownership are often run as much for government benefit as for their shareholders. Problems arise for investors when these interests are not aligned and possibly affect their profitability and future returns. Companies that align management’s and shareholders’ interests are considered compliant with the 'G' in ESG (environmental, social and governance) factors used to measure sustainability and responsibility.”

Why It's Important

There has been consistent debate regarding the ability of ESG strategies to outperform traditional equity benchmarks. Some research suggests ESG investing is efficacious in emerging markets.

While XSOE isn't a dedicated ESG fund, it proves that point. Over the past 36 months, the WisdomTree fund is beating the MSCI Emerging Markets Index by almost 700 basis points with slightly less annualized volatility. Data also indicate emerging markets SOEs also fail investors when it comes to return on equity (ROE).

“Another area of consideration has to do with fundamentals,” said WisdomTree. “If, in fact, SOEs are managed in ways that do not favor shareholders’ interests, this should show up in “lower quality” or “less efficient” fundamental metrics. Using ROE as a quality proxy, we can see how non-SOEs had a distinct advantage over this time period.”

What's Next

The $306.71 million XSOE only includes companies in which government ownership is 20 percent or less. As such, the fund is only lightly allocated to ESG-offending sectors, such as energy, materials and utilities. Consumer cyclical and technology stocks combine for over 35 percent of the fund's weight.

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