Ready to emerge into new markets? Harness developing potential with climate-friendly ETFs
- 06 August 2024 (3 min read)
Emerging markets have the potential to offer investors exposure to diverse and attractively-priced opportunities. Nevertheless, access to the long-term growth trajectory of less mature markets is often associated with a higher volatility profile, and increased exposure to the risk of adverse geopolitical developments. Read on to discover how ETFs could help investors to access this significant growth potential in one convenient transaction – whilst retaining the agility to respond to short-term tactical market developments, and promoting decarbonisation targets.
The case for emerging markets
investing in the world’s developing economies has always been synonymous with the high-risk, high-reward mantra. The more typical problems associated with them include political – and often geopolitical instability, lax regulation, and a lack of transparency in company information, compared to developed markets. Additionally, emerging markets have slipped off many investors’ radars due to a run of lacklustre performance, but the improving economic backdrop and the prospect of lower US interest rates suggest now might be the time to reassess their potential.
There is a myriad of reasons to consider emerging markets from a long-term perspective, including numerous economic and demographic advantages – they are the chief drivers of overall global growth, accounting for 50.1% of global GDP in 2023, and 66.7% of global GDP growth in the prior decade.1
They are also enjoying rapid industrialisation, house most of the world’s population, have a young workforce - more than 40% of India’s population is under the age of 25 - and enjoy a rapidly growing middle class.2 One analysis estimates that by 2030, most emerging market consumers, at 75%, will be between the ages of 15 and 34 – and will be more optimistic about the economy and willing to spend.3
Megatrends such as decarbonisation, technological innovation and the growth of artificial intelligence (AI) are also helping drive growth. In China, for example, between 2021 and 2022 electrical vehicle (EV) sales jumped from 1.3 million to 6.8 million – representing more than a third of the world’s EV sales in 2022.4 Equally, the adoption of AI is expected to help increase productivity and drive transformation across a wide spread of industries across emerging markets.
How might investors with specific risk, liquidity, or decarbonisation investment goals seek to include the untapped potential of emerging markets within their portfolios?
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Introducing Climate Paris-Aligned (PAB) ETFs – designed to widen access to emerging markets
While developed nations and regions such as the USA, UK and EU have been leading the way by implementing responsible investment requirements, legislation, and commitments to net zero, there may remain a perception amongst investors that emerging markets have some catching up to do in this area – not least with disclosure capabilities. Arguably, those regions and companies with the greatest potential to improve and grow could find themselves in a vicious circle of needing to attract funding in order to improve their ESG capabilities and operations, while being excluded from the capital flows needed to help achieve this. Yet, the scale of population and share of global GDP which resides amongst emerging markets has led to some market commentators labelling them the ‘growth engine of the future’.5 How, then, might responsibly minded investors justify the inclusion of this potential within their investment parameters?
Major index providers such as ICE® and MSCI® now offer a range of Paris-aligned indices. These indices, when combined with the benefits of an index-linked ETF, can offer investors flexible, more liquid and convenient access to the growth potential of emerging markets. While this long-term opportunity may have been historically overlooked by investors on environmental, social or governance (ESG) grounds, these indices boast the additional benefit of more closely aligning investment goals with the objectives of the Paris Agreement, the global treaty designed to strengthen the global response to climate change.
Fixed income investors can take advantage of ETFs which track ICE®’s range of Paris-aligned indices. These ‘…are subject to the requirements for labelling as Paris-Aligned Benchmarks under EU and UK BMR. Indices are available that measure carbon reduction in terms of absolute carbon emissions or in terms of EVIC-based carbon intensity. The indices exclude companies with fossil fuel exposure and require at least a 50% carbon reduction compared to the Parent Index.’6
Meanwhile, MSCI®’s Emerging Markets Climate Paris-Aligned Index is designed to reduce equity investors’ exposure to transition and physical climate risks, and to pursue opportunities arising from the transition to a lower-carbon economy while aligning with the Paris Agreement requirements. The Index incorporates the Task Force on Climate-related Financial Disclosures (TCFD) recommendations (which are complementary to the EU Paris aligned benchmark requirements) and intends to exceed the minimum standards of the EU Paris aligned benchmark requirements.7 Naturally, this comes with a negligible exposure to the energy sector compared to its parent index, the MSCI® Emerging Markets Index, while retaining diverse sector exposure across 24 emerging markets countries.8 The PAB Index tends to be overweight the industrials sector compared to the MSCI® Emerging Markets Index (15.25% versus 6.92% as at 28 June 2024)9 . This may be of significant interest to investors wishing to align their portfolios with the wider decarbonisation trajectory; the industrials sector contains many companies engaged in the production and development of renewable energy sources such as solar, wind, battery and more. Notable names within the PAB index10 include Korean firm EcoPro Co., which specialises in developing air pollution control solutions such as chemical filters and cathode materials for next-generation batteries.11 India-based Suzlon Energy Ltd is a major renewable energy solutions provider with presence across 17 countries globally. The 20,780-megawatt capacity it has installed worldwide is equivalent to the energy required to power over 13 million households, and prevent over 53 million tonnes of CO2 emissions, on an annual basis.12
While challenges undoubtedly remain ahead for emerging markets’ growth trajectory, accessing their dynamic growth potential through the liquidity of an ETF could now represent a potentially solid, long-term investment opportunity – without compromising on decarbonisation goals.
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