Asia’s top ESG funds are reaping the rewards of investing in Japan, a market largely ignored even by local money managers focused on sustainability.

Four of the five best performers in the region this year are focused on Japan, boasting total returns of more than 17%, according to data compiled by Bloomberg of ESG funds with at least $250 million in assets. That tops the average gain of 1.1% for Asian ESG funds overall, and the 16% return for Japan’s Topix stock gauge.

Money managers with sustainable mandates in Japan have generally avoided their domestic market, citing relatively low returns and subpar environmental, social and governance practices. Those that have stuck close to home are benefiting from improved corporate governance, a dose of inflation and an endorsement from billionaire investor Warren Buffett. That’s compounding optimism about Japanese stocks, which have been among the best performers in the world this year.

The Alma Eikoh Japan and Goldman Sachs Japan Equity Partners join the top Asia ESG funds this year, with returns of more than 20% each. The Alma Eikoh fund has seen gains from industrial companies including Japan Airlines Co. and Mitsubishi Heavy Industries Ltd. The former is raising billions of yen for transition financing while the latter is seeking to use hydrogen and carbon-capture technologies to reduce carbon emissions. Almost a quarter of the Goldman Sachs fund’s weighting is in technology firms like Sony Group Corp.

ESG-focused funds comprise investments with general attributes including a focus on climate change and clean energy as found in Bloomberg data.

Mid-Cap Bets

Japanese mid-cap stocks meanwhile are helping the performance of the iMGP - Japan Opportunities fund, which has beaten 90% of peers this year, according to Bloomberg data. The Tokyo Stock Exchange’s January push for companies to boost their return on equity and get their prices above book value is geared toward small- to-mid-caps, said money manager Joël Le Saux.

Mid-caps may not be the “best in class in terms of ESG rankings” but that doesn’t mean their ESG performance is poor, said Le Saux, whose so-called Article 8 fund gets its designation from buying portfolio companies that have better ESG scores and emit less carbon than the benchmark.

“They just don’t have the resources to write the nice reports that ESG ratings agencies like” and are penalized for it, he added.

For Japan, the big risk from an ESG perspective will be environmental as emissions regulations kick in, he said. The world’s fifth-biggest emitter has started pricing carbon with a voluntary emissions trading scheme this year.

However, progress on the corporate governance front for Japan is clear to some. Companies are adding more independent directors and carrying out more share buybacks to boost returns, said Samuel Lo, a senior analyst at Morningstar Inc.

--With assistance from Gregory Turk.

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