Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 211

3 difficulties investing in emerging markets

Investing in emerging markets is fraught with complex challenges and dealing with them calls for a new approach based on sustainability. Traditional fundamental analysis and quant models have come up short.

Investors encounter three key problems: the negative impact of state-owned enterprises (SOEs); a lack of emphasis on good governance and sustainability; and high fees and index constraints.

1. Alignment of interests by SOEs

State-owned enterprises, which make up about 30% of the emerging markets benchmark, usually have different objectives to minority investors. Investors need to understand whether their interests are aligned because shareholder wealth creation reduces risk and increases returns.

According to a report in The Economist, the SOEs among the world’s top 500 companies lost between 33% and 37% of their value between 2007 and 2014. Global shares rose by 5% over the period. The root of the problem, according to The Economist, is a “huge misallocation of capital.” With little need to meet the expectations of investors, SOEs invested trillions of dollars in non-core businesses that did not pay off. SOEs are also stingy when it comes to paying dividends and many have debt problems.

2. Poor governance and inadequate stewardship

Companies with poor governance and sustainability practices add cost to their operations. As a result, they have less capital for investment and less that can be distributed to shareholders. We believe ESG (Environment, Social and Governance) in emerging markets is under-researched and gives us a competitive advantage that adds value.

The single most important ESG factor is governance. Governance issues include audit quality, compensation policies, board independence, capital discipline, related party transactions, management quality, past violations and controversies involving the company.

There is strong evidence of the positive role governance plays in driving superior financial and market performance, while lowering risk. In 2012, Deutsche Bank compiled research on more than 100 global studies on the merits of ESG. The studies found that companies with high ESG ratings have lower capital costs. The most important factor was governance, with an emphasis on stewardship of capital. Harvard Business School published research in 2015 (Serafein et al) which concluded: “We find that firms with strong ratings on material sustainability issues have better future performance than firms with inferior ratings on the same issues.”

Company sustainability reports and third-party research to assess the transparency and integrity of company disclosures are also important. We place the company’s environmental and social practices in their industry context and seek to identify cases of ‘greenwashing’.

3. Fees and difficulties constructing a good index

Quant funds have yet to make meaningful inroads into ESG investing in emerging markets. The available data sets are relatively immature and there are reliability issues resulting from the wide variability of company reporting. It can be difficult to compare companies on a like-for-like basis. It is expensive to source data in emerging markets which can often be corrupted by companies using ‘greenwashing’ and other techniques to disguise the true nature of their business practices.

There seems to be a price at which an active fundamental investment manager will tolerate certain poor qualities, hiding under the veils of ‘it being discounted into the price’ or ‘growth cures all problems’. There is a tendency to interpret information in a way that confirms already held preconceptions.

Sustainability issues often take a secondary role to price, growth and risk management considerations. Other investment managers look at valuations and short-term earnings expectations, and if they see a good deal they will explain away poor governance practices.

Index management is not a viable solution in emerging markets either, due to two fundamentally disqualifying facts mentioned above: the role of SOEs and the pervasive influence of poorly-governed companies. The inconsistent application of the rule of law across disparate geographies and weak sustainability practices ensure poor long-term returns from many companies represented by the benchmark.

 

Craig Mercer is Co-founder and Chief Investment Officer of Remerga. Remerga emphasises corporate governance and sustainability in the emerging markets. Remerga’s Emerging Markets Sustainable Leaders Fund does not hold any state-owned enterprises. This article is general information and does not consider the circumstances of any individual.


 

Leave a Comment:

RELATED ARTICLES

Beyond the acronym, navigating important ESG choices

Investment learnings from the COVID-19 crisis

Is it a myth that 'purpose' can drive corporate profits?

banner

Most viewed in recent weeks

The case for the $3 million super tax

The Government's proposed tax has copped a lot of flack though I think it's a reasonable approach to improve the long-term sustainability of superannuation and the retirement income system. Here’s why.

7 examples of how the new super tax will be calculated

You've no doubt heard about Division 296. These case studies show what people at various levels above the $3 million threshold might need to pay the ATO, with examples ranging from under $500 to more than $35,000.

The revolt against Baby Boomer wealth

The $3m super tax could be put down to the Government needing money and the wealthy being easy targets. It’s deeper than that though and this looks at the factors behind the policy and why more taxes on the wealthy are coming.

Meg on SMSFs: Withdrawing assets ahead of the $3m super tax

The super tax has caused an almighty scuffle, but for SMSFs impacted by the proposed tax, a big question remains: what should they do now? Here are ideas for those wanting to withdraw money from their SMSF.

The super tax and the defined benefits scandal

Australia's superannuation inequities date back to poor decisions made by Parliament two decades ago. If super for the wealthy needs resetting, so too does the defined benefits schemes for our public servants.

Are franking credits hurting Australia’s economy?

Business investment and per capita GDP have languished over the past decade and the Labor Government is conducting inquiries to find out why. Franking credits should be part of the debate about our stalling economy.

Latest Updates

Superannuation

Here's what should replace the $3 million super tax

With Div. 296 looming, is there a smarter way to tax superannuation? This proposes a fairer, income-linked alternative that respects compounding, ensures predictability, and avoids taxing unrealised capital gains. 

Superannuation

Less than 1% of wealthy families will struggle to pay super tax: study

An ANU study has found that families with at least one super balance over $3 million have average wealth exceeding $19 million - suggesting most are well placed to absorb taxes on unrealised capital gains.   

Superannuation

Are SMSFs getting too much of a free ride?

SMSFs have managed to match, or even outperform, larger super funds despite adopting more conservative investment strategies. This looks at how they've done it - and the potential policy implications.  

Property

A developer's take on Australia's housing issues

Stockland’s development chief discusses supply constraints, government initiatives and the impact of Japanese-owned homebuilders on the industry. He also talks of green shoots in a troubled property market.

Economy

Lessons from 100 years of growing US debt

As the US debt ceiling looms, the usual warnings about a potential crash in bond and equity markets have started to appear. Investors can take confidence from history but should keep an eye on two main indicators.

Investment strategies

Investors might be paying too much for familiarity

US mega-cap tech stocks have dominated recent returns - but is familiarity distorting judgement? Like the Monty Hall problem, investing success often comes from switching when it feels hardest to do so.

Latest from Morningstar

A winning investment strategy sitting right under your nose

How does a strategy built around systematically buying-and-holding a basket of the market's biggest losers perform? It turns out pretty well, so why don't more investors do it?

Sponsors

Alliances

© 2025 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.