Patrick Thomas, head of ESG investments at Canaccord Genuity Wealth Management, has warned combining emerging markets and ESG will not deliver the sustainable impact investors desire.

Speaking at ETF Stream’s Big Call: Emerging Markets event, Thomas (pictured) said he was “highly sceptical” of the financial industry packaging products in emerging markets and then adding an ESG label onto them in order to increase assets under management (AUM).

The reason for this, he stressed, was because investing in areas such as China, which makes up a large proportion of major EM ESG indices does not make sense for an investor that is looking to have an environmental and social impact.

China still accounts for a large proportion of major ESG indices. For example, the MSCI Emerging Markets ESG Leaders index has a 41% weighting to Asia’s largest economy, just 1.5% less than its parent MSCI Emerging Market index, as of 31 August.

“It is a challenge including China in an emerging market ESG index,” Thomas continued. “If you are serious about ESG, then you should not be comfortable with their labour rights practices and corporate governance.

“Investors have to accept that they are underweighting this particular region and as a result will miss out on future returns because they genuinely care about social issues.”

There are a number of ESG ETFs that offer exposure to emerging markets in Europe including the $770m iShares MSCI EM IMI ESG Screened UCITS ETF (SAEM) and the $565m Xtrackers MSCI Emerging Markets ESG UCITS ETF (XZEM), the two largest on the market.

Combining ESG and emerging markets has outperformed in the short and long term, however. The MSCI Emerging Markets ESG Leaders index has returned 5.9% versus 0.7% for the MSCI Emerging Markets index, as of 31 August, while over the past decade it has delivered annualised returns of 7.6% versus 4.1%.

However, Thomas said the story has been similar to developed markets where sector biases towards tech and against energy have helped deliver this outperformance.

“I view emerging markets as effectively developed markets on steroids,” he said. “The tech bet investors make with the MSCI World is even more extreme with emerging markets.”

He added the outperformance of ESG over the past three years had moved the conversation on from the point where investors were happy with short-term underperformance if this meant avoiding certain companies due to conflicts with widely held social and environmental beliefs.

“I think this point has been lost.”

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