Socially responsible investing in emerging markets was never easy, but Russia’s invasion of Ukraine has investors reassessing how to rate emerging markets on environmental, social and governance grounds.

A number of ESG emerging-market exchange-traded funds had Russian holdings just as the war began in late February, according to Morningstar data. Among them were the $6.3 billion iShares ESG Aware MSCI EM ETF
ESGE,
+1.23%
,
the $3.2 billion WisdomTree Emerging Markets ex-State Owned Enterprises ETF
XSOE,
+1.20%

and the $702 million Xtrackers Emerging Markets Carbon Reduction & Climate Improvers ETF
EMCR,
+1.32%
.
Like non-ESG funds, these ETFs fell sharply as investors sold Russian assets.

Additionally, plenty of market commentators questioned why an ESG fund would own Russian assets at all.

To take a step back, ESG investors sometimes saw emerging markets as a way to do well by do good in parts of the world that have always mixed high risk with high reward. In Alex Edmans’ book about sustainable investing, “Grow the Pie,” the professor of finance at London Business School points to Vodafone’s
VOD,
+2.51%

VOD,
-0.70%

M-PESA mobile banking platform in Kenya, which allowed unbanked Kenyans access to digital money and also created a new business line for Vodafone.

But now Russia’s war has increased scrutiny of governance-related issues there and in other markets, says Jay Truesdale, CEO of Veracity Worldwide, a strategic intelligence firm that focuses on ESG, political and reputation-related risks.

“It’s exposed the way in which the Kremlin governs Russian society, and it shined a light on internal corruption and dysfunction within Russia’s economy. Many investors are saying to themselves that if this collective situation in Russia gives us pause, then we should be much more aware of and focused on other places that could have analogous dynamics,” Truesdale says.

Read: A dirty secret: Here’s why your ESG ETF likely owns stock in fossil-fuel companies

Prior to the invasion of Ukraine, some Russians firms targeting foreign investors had the most aggressive targets for reducing greenhouse gases, says Charlie Wilson, portfolio manager for the $1.1 billion Thornburg Investments Developing World Fund
THDAX,
+1.07%
.
Several Russian commodity producers had extensive ESG disclosures that rivaled those in developed market.

“Corporates in Russia knew that they had the overhang of a government system that didn’t provide the level of transparency that most global investors would want. And so the corporates took it on themselves to provide more transparency and to be leaders in ESG,” Wilson says, whose fund uses ESG as an extension of its stock-selection process to mitigate risk and identify investment opportunities in emerging markets.

He points to Russian steel company Severstal
RU:CHMF,
which had greenhouse-gas-reduction targets for nearly a decade and is one of the most efficient global steel producers. Others include Lukoil and Novatech
RU:NVTK,
two very low-cost liquid natural gas producers that were helping some countries to reduce their dependence on coal. Those companies were trading a significant discount to their global peers, he says.

The fund sold its holdings in those companies before war broke out.

Read: Can I beat the stock market with ESG investing? How to find the best fund for you

Thinking about emerging-market investing now

There’s no doubt that ESG investing in emerging markets has special challenges, says Perth Tolle, founder of Freedom & Liberty Indexes, which runs the $200 million Freedom 100 Emerging Markets ETF
FRDM,
+1.12%

that uses an index to invest in countries with higher human and economic freedom scores.

Many emerging markets are still autocracies or are exiting autocratic rule and don’t have the governance foundations found in developed markets, such as basic human rights and freedom of speech, media and expression that can act as independent verification of corporate and government data, she notes. As a result her fund excludes China, Russia, Turkey and a few other emerging-market countries.

Read: New York pension program throws weight behind shareholder efforts to stop banks funding new oil

ESG as a concept remains fairly new in Asia, which means corporate disclosure is limited and there is often little visibility into supply chains, says Elsa Pau, founder of Hong Kong-based ESG analysis and modeling platform BlueOnion. The firm’ analysis relies in part on web scraping and other advanced data collection.

Still, a few companies are making strides. Pau cites Chinese healthcare firm Novogene
688315,
+3.37%

as an example. It is highly rated on issues material to a managed healthcare and healthcare facilities company, such as in data privacy, product quality and safety, and customer protection and satisfaction, she says. It also has high marks for its working conditions.

“The company is falling short on human rights and (is) second-best in business ethics compared to peers, but generally, the entire sector has a relatively lower governance score,” she says.

Wilson, the Thornburg Investments manager, points to a relatively new Brazilian investment management company, XP
XP,
+0.80%
,
which he calls the “Charles Schwab of Brazil.” In addition to offering fintech in Brazil, the firm focuses on workplace diversity, work-life balance and employee benefits.

“The thing that ESG analysis can help you with is digging in on how they approach material issues that are specific to that industry. That can really help you to identify companies that are likely to outperform,” he says.

A word of caution

Wilson says investors who want to apply ESG factors to emerging-market countries need to do so carefully. He takes a twofold approach, using bottom-up fundamental analysis overlaid with country-specific risks. Investors need to decide for themselves a country’s risk.

“I think every country has different risk factors,” he says.

Debbie Carlson is a MarketWatch columnist. Follow her on Twitter @DebbieCarlson1.

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