By Carolyn Cohn
LONDON (Reuters) - Cajoled by developed world governments and shocked by disasters such as the Bangladesh factory collapse, investors in emerging market companies are looking more closely at environmental, social or governance issues before they buy.
Once the preserve of religious and ethically minded funds and the development finance arms of major economies, these ESG themes have moved into the mainstream.
Almost all emerging fund managers in a survey by UK development finance arm CDC to be published this week consider ESG to be integral to their investment strategy, and in many deals they regard it as a "fact of life".
It is a sharp contrast to a few years ago, when emerging market investors saw sustainable strategies as an irritant imposed by worthy multilateral lenders, or "the dead hand of eco-fascism", according to CDC's ESG director Mark Eckstein.
The global financial crisis showed that companies needed to have strong governance to be financially sustainable.
And disasters such as the fatal Rana Plaza garment factory collapse in Bangladesh this year illustrate the importance of social considerations such as health and safety procedures.
"We are beginning to see questions from investors such as 'Is this company going to be in business in five years' time?'," said Eckstein.
"There is a step up in investors' sophistication - they are taking ESG seriously because it is an issue for them."
CDC's own investments include Halonix, an Indian firm that makes halogen bulbs for cars, and a steel plant in Kenya with a strong health and safety policy.
Sustainable investing has mushroomed. Such assets under management in Europe jumped to over $8 trillion in 2010 from next to nothing in 2005, according to HSBC, and total about $3 trillion in the United States.
But the strategy is seen as particularly likely to reap returns in emerging stocks - even though some market participants remain unsure of the consistency of returns.
"Especially in emerging markets, governance matters," said Gary Greenberg, head of global emerging markets at Hermes.
"We are past the point when you can hide the pollution or bad practice."
Hermes runs an emerging equity fund for U.S. ethical investment fund Calvert Investments. The fund has seen an 11.6 percent return this year before sales charges, compared with a 4.7 percent fall in the MSCI emerging stocks index <.MSCIEF>.
Investing in a way that removes ESG risks could boost returns in an emerging equity portfolio by up to 50 basis points, according to a 2011 study by Allianz Global Investors, with emerging equity the asset class most likely to benefit.
But definitions of the stocks most suitable to invest in can be muddled, and reliable outperformance hard to prove.
"I think it's random and we have been doing it for 25 years," said Brian Langstraat, CEO of fund manager Parametric, which constructs portfolios for clients and has an emerging market focus. He said investors are "aligning their investment to their values, not because they are going to be paid".
Should the U.S. coffee shop chain be among listed companies in a sustainable equity portfolio, because of its work with fair trade coffee farmers?
Or should it be blacklisted, because of the perceived detrimental impact which the group's 20,000 shops worldwide have on local businesses, or accusations it did not pay enough tax in past years on its UK business? [ID:nL3E8LB481]
Following widespread criticism from politicians and the picketing of stores, Starbucks said it would pay or pre-pay around 10 million pounds a year in taxes in 2013 and 2014.
Investors may hold a variety of views on Starbucks, showing the difficulties of identifying an appropriate investment.
Contradictory requirements from investors are among the biggest hurdles to employing an ESG strategy in private equity, according to the CDC survey.
In a history which dates back to Quaker investments of the 16th century, sustainable investing has gone through a number of guises. The number of different terms used to describe it tends to add to the definition confusion.
Investors have moved on from straightforward ethical investing, which involves kicking out "sin stocks" such as drugs, weapons, pornography or gambling, as represented in the iconoclastic Vice Fund
Fund managers controlling assets totaling $34 trillion have signed up to abide by the United Nations' Principles of Responsible Investing (PRI) launched less than a decade ago.
"People tend to dismiss some of the issues as touchy-feely and nice to have, that's not what the research shows," said Fiona Reynolds, managing director of UN PRI.
UN PRI highlights a 2010 study of 114 of the largest Chinese listed companies. Those underperforming socially had lower stock performance than companies with good ESG practices.
BAD TO GOOD?
Similarly, a survey last year by Deutsche Bank of more than 100 academic studies showed that globally, firms with high ratings for corporate social responsibility and ESG factors had a lower cost of capital.
"In effect they are lower risk," Deutsche said.
But the chances of making money out of the strategy are less clear cut. The Deutsche survey also said that 88 percent of studies of fund returns showed neutral or mixed results, and that funds with a socially responsible badge "have struggled to capture outperformance ... but they have, at least, not lost money in the attempt".
But if being good does not always pay, maybe being bad does - the Vice Fund, run by USA Mutuals, has matched the glittering performance of the S&P 500 <.SPX> this year with a 26 percent gain, outstripping a 22 percent rally in the Ave Maria Catholic Values Fund
Private equity funds in emerging markets complain that the focus on ESG stops them from buying into "bad" companies and cleaning them up, potentially a lucrative move.
Good practices can also be expensive, such as providing low-paid employees with health insurance.
"Some of those principles make you uncompetitive," said one private equity fund manager, adding that ESG investing was not really necessary to help the developing world.
"If you're putting money in emerging markets, you're making a positive impact."
(Corrects to show Rana Plaza factory was collapse, not fire)
(Additional reporting by Shadi Bushra, Julia Fioretti and Sujata Rao; Editing by Alison Williams)