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ESG bond funds

By EBI Portfolios

Posted on September 27, 2019 under finance

It is usually the case that any innovation or evolution in the ETF industry benefits equities first. Equity ETFs have launched in every category, from the smallest corners of the globe in terms of geography to smart beta and beyond. Fixed income and other asset classes, on the other hand, always take longer to achieve the same level of progress.


ESG is no exception. Data from Morningstar as of July this year shows the vast bulk of assets and number of funds relating to ESG investment in Europe is in equities. In fact, there are only eight so-called sustainable bond ETFs in the region. There are currently only three providers offering these fixed income funds - db x-trackers, iShares and UBS, and their products are mostly invested in corporate bonds.


While ESG is still gaining traction, it may be the case that ETF providers think launching ESG equity ETFs is a safer bet. A new fund, I’ve been told, often needs to break the $100 million asset mark before breaking even, depending on the asset class, and the large index providers charge a premium for any benchmark that is not plain vanilla equity.


Another major reason there are not more fixed income ESG ETFs is due to the securities available to make up an index which an ETF can track.


Let’s look at two examples to make the point clear.


In equities, the iShares MSCI USA UCITS ETF has 637 holdings, but its SRI-focused counterpart, the iShares MSCI USA SRI UCITS ETF, has just 150 constituents.


In the fixed income space, the UBS Bloomberg Barclays Euro Area Liquid Corporates UCITS ETF has 820 index constituents and its sustainable counterpart ETF has 624.


It is clear that, especially since the process of ‘negative screening’ is the most popular method for constructing an ESG or SRI benchmark in Europe, there will be far fewer securities or constituents compared to its parent index. And funds can only be shaved down so far before there is concentration risk.


As a result, the criteria for selecting bonds in a so-called sustainable fund will be looser than for equities.


Take MSCI, which is by far the largest index provider for ESG ETFs in Europe. MSCI’s ESG scoring lays out seven bands for companies, from AAA to CCC, analysing everything from climate change and corporate governance to pollution and human capital. For any company to be included for consideration in an ESG equity index, it must have at least a single A.


Within fixed income, the criteria is less strict. The Bloomberg Barclays MSCI Sustainability Indexes select issuers from the parent index using MSCI ESG ratings as a “best in class” assessment - and the issuer must have a BBB rating or better. There are four bands instead of seven, which ensures there are enough bonds to choose from.


Fixed income ETFs have long had their quirks, so the above may not be surprising to financial advisers. For example, a physically replicated fixed income ETF does not usually hold the hundreds of exact same bonds as in the index as it would be impossible for an ETF manager to trade in and out of so many. As a result providers often use “optimised sampling” or “stratified sampling” techniques to pick their own bonds and produce the same returns as the index. This quirk also applies to the ESG bond arena.


For all of the reasons above, there is a severe lack of choice in the fixed income space. EBI Portfolio’s upcoming Earth portfolios do not contain any ESG fixed income funds. This is a situation we hope will change in the near future as we believe there should be enough options of ESG funds in every asset class.