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The investment case for ESG in fixed income index investing

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Exchange traded funds (ETFs) incorporating environmental, social and governance (ESG) criteria have seen rapid growth, particularly over the past few months, with momentum accelerating in spite of the COVID-19 global pandemic.

Indeed, investors that are coming back into the market after the disruption of the pandemic are increasingly opting for the sustainable versions of ETFs, a clear sign that investors want to “build back better” and see sustainable investing as their new industry standard.

To give investors more clarity and confidence in building sustainable portfolios across asset classes, iShares, in partnership with Responsible Investor, held a webinar looking at the investment case for ESG in fixed income index investing. With fixed income ESG ETFs showing greater resilience compared to their ‘standard’ peers, we felt it was a good time to explore the opportunities of taking a sustainable approach to bond portfolio construction.

The webinar featured Brett Olson, Head of iShares Fixed Income ETFs (EMEA) at BlackRock and James Gloak, Vice President, Sustainable Investing iShares (EMEA) at BlackRock. It was moderated by Daniel Brooksbank, Head of Strategic Content at Responsible Investor.

Gloak opened up the session by explaining some of the key differences between equity and fixed income sustainable ETFs, although he said the majority of sustainable indexes across those asset classes do involve similar elements of ESG incorporation.

There are three main criteria that are incorporated in sustainable indexes, when moving from a traditional “parent” index to a sustainable index: business involvement exclusion criteria; ESG Ratings; and ESG Controversies.

Business involvement exclusion criteria are screens that eliminate issuers with exposure to activities that are incompatible with an investor’s values, whether that be controversial weapons, tobacco or, more recently, thermal coal. This type of screening has been around for a while, having originally been a tool for active managers.

Moving to ESG ratings, Gloak explained that this is where an ESG data provider looks to assess the underlying environmental, social and governance risks or opportunities within a company and how well they are managing or mitigating those risks.

He said companies that identify and mitigate those risks are more likely to have for example, more stable and sustainable supply chains, stronger corporate governance, and may be better at attracting as well as retaining employees, all of which may make the company more resilient during periods of volatility.

Top ESG performers may also be less exposed to privacy and data security failings or health and safety incidents. A sustainable index can set an ESG rating threshold which has to be met in order for companies to be eligible.

The next step of sustainable index construction is ESG controversies. This is where data providers look at a company’s exposure to controversies that have occurred, as well as their adherence to international norms and principles. 

Whereas an ESG rating can be seen as a forward-looking metric as it is assessing a company to see if there’s ESG risks or opportunities that could be of a material significance to it, ESG controversies can be seen as a backward looking metric as they assess incidents that have already occurred to the company. A controversy happening at a company may indicate underlying ESG risks that have not been mitigated by management and which could be detrimental to a firm’s financial performance. Again, sustainable indexes can have a controversy threshold thereby removing those that do not meet it.

Gloak said these are the matching elements between iShares’ fixed income and equity ESG index construction. Some equity strategies go a step further and are more selective above and beyond those that have already met the first 3 criteria, such as only taking the top ESG performers in each sector.

 

A breakthrough year

Discussion moved on to the massive growth seen recently. “Over the past 18 months we have seen really significant growth in the EMEA sustainable ETF market,” Gloak said. 

“It felt like we were treading water in the years after the 2015 Paris climate talks and it wasn't until the end of 2018 that there was a confluence of media interest, investor interest and impending regulation.

“I think we can say that, for sustainable ETFs, 2019 really was a breakthrough year.”

Net new business (NNB) almost quadrupled for Sustainable ETFs in the EMEA region, growing from $5bn at the end of 2018 to $18.5bn at the end of 2019: “So really positive growth.”

He added that fixed income ESG ETFs are a relatively newer development. At the end of 2017 there were just seven fixed income sustainable ETFs in the EMEA market with just under $900m in assets under management (AUM). At the same time, the equity form numbered 37 with just under $6bn in AUM - the benefits of an earlier start.

But fast-forward to 2019’s “breakthrough” saw 11 sustainable fixed income ETFs launched, effectively doubling the market. This trend has continued into 2020 with another 11 launches. This has “really helped take sustainable fixed income ETFs to new records” Gloak said. The flows of $4bn seen in 2019 have already been surpassed this year.

The greater selection of products now available that have also achieved “critical mass”, allows investors more choice when looking to transition from standard portfolios to sustainable ones. 

Next to speak was Brett Olson, who pointed out that we can’t talk about ESG without thinking about where fixed income ETFs fit into the picture - now and in the future.

He explained how, while the equity market is huge, at around $40 trillion, the fixed income market is over twice that size at over $100 trillion. Although fixed income ETFs still make up a small percentage of that overall figure, their share is growing.

To give some context, Olson noted how it took 17 years for fixed income ETF industry to reach a trillion dollars. “That was in June 2019. At that time our prediction was that the industry would hit $2 trillion by 2024. Fast forward around 16 months and we are already at $1.4 trillion. So we are seeing that acceleration of adoption taking place.”

 

He outlined four key drivers.

  1. An evolution of portfolio construction
  2. Modernisation of the bond market
  3. Constant ETF innovation 
  4. Growing adoption

On the first point, an evolution of portfolio construction: more investors are thinking about what are the outcomes they want to achieve, and how to do it most cost effectively. 

“We would argue that MiFID 2 [the revised EU Markets in Financial Instruments Directive] has played a role in it, boosting transparency requirements. Investors are looking at how to build a portfolio, often ‘barbelling’, that is to say using indexes at the core combined with high conviction alpha seeking strategies as well.

Another factor is the modernisation of the bond market, which has lagged the equities market in terms of electronic trading. It wasn’t so long ago that trade tickets were written by hand, however today an ever-greater number of trades are done via electronic platforms.

Tied to this is the continuous innovation in the ETF space itself. “What we’re looking to do is provide solutions for investors,” Olson said.

And the fourth element that is driving the growth is a growing adoption of ETFs by a whole range of clients, from asset owners and asset managers to wealth and retail investors. “It  is not just one client segment adopting or increasing usage of FI ETFs, we are seeing it across all client segments. It has democratized investing for many investors.”

These different client segments are also using ETFs in different ways, whether as a “liquidity sleeve” to manage flows and be fully invested, or as a tactical (short to medium-term) or strategic (long-term) asset allocation tool. They also have a role in portfolio transitions, in corporate treasuries or as a derivative complement, Olson said. So, there were multiple uses for ETFs by different client segments. 

How did the sector fare during the pandemic-related volatility this year? 

Overall, net new business (NNB) dipped in the February/March period at the height of the crisis then picked back up quickly once there were coordinated policy efforts, Olson said.

But he noted how sustainable ETFs stayed solid, with investors “continuing to allocate to sustainable ETFs”. He said that as investors started to re-risk after the February/March period, more money went into sustainable ETFs than was anticipated.

This time was a “critical point for the ETF industry, particularly on the fixed income side” he said. “It was a true test for what was happening in the marketplace, a test of how well the structures performed with pretty much all of the fixed income marketplace being stressed at the same time. 

“What we saw was that more money turned to ETFs. We went from just under $8bn weekly average trading volume in 2019 up to as high as $21bn during one of the weeks in March.”

“What it proved once and for all is that the structure works extremely well; ETFs not only provided investors with a tool to navigate the market, but also fixed income ETFs became price discovery tools. And from an ESG perspective, more and more investors are turning to ESG as they were re-risking.”

2:00 pm BST on Thursday 22nd October 2020

*This webinar is for those based in EMEA. For qualified investors in Switzerland: This document is marketing material.  The information contained in this document is intended strictly for Professional Clients as defined under the Dubai Financial Services Authority (“DFSA”) Conduct of Business (COB) Rules.

* For professional clients and qualified investors only

 

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