Passive ESG bond exposure: pros and cons
Jack Turner, an investment manager for 7IM, argues that many people are “too quick to discount the merits of passive ESG investing”, often for the same reasons some dislike passives more generally.
But there are reasons to favour a passive approach for ESG-friendly bonds. The companies looking to construct or use baskets of ESG bonds, from index providers to large asset managers, tend to have huge resources that should help them navigate this landscape.
Passive bond plays can also be cheap, transparent, and sometimes offer significant diversification through sheer number of holdings.
But they do face challenges. Generally, the investor always makes an “active” choice of index, and it can be crucial to closely assess the underlying investments when choosing ESG trackers. A fund could, ultimately, hold something that does not chime with a client’s beliefs.
Bond passives come with specific issues, too. Matt Brennan, head of passive portfolios at AJ Bell, notes that ESG equity indices such as MSCI’s SRI index range can exclude “bad” companies and take big positions in the names that score best on the relevant metrics.
But limited bond liquidity means such as an approach would not work within fixed income products. “This means the bond indices only make small tilts towards the best ESG companies,” he adds. “As such, the uplift versus the non-ESG indices is much smaller than [for] ESG equity indices.”
Bond markets have also tended to be less transparent. Specialists have previously warned that while companies with listed shares must make significant disclosures, not all bond issuers will provide the same level of information. This makes it harder to assess a bond issuer’s ESG credentials.
However, some have cited big improvements here. Ms Pachatouridi says: “Things have changed significantly. If you go to high yield and emerging market debt, the amount of reporting that has come out has increased materially. They [issuers] do care about ESG scores because they care about their corporate debt being included in major indices run by the largest investors in the world.”
Improved disclosure by bond issuers, and substantial analysis from research companies and index providers, is resulting in a clearer picture. Mr Turner notes, for example, that MSCI’s sustainability data now covers 94 per cent of the bond issuers in the Bloomberg Barclays US Credit index – up from 75 per cent in 2013.
This, and the proliferation of such products, could ultimately mean that bond passives play a larger role in an ESG-oriented portfolio. But they may require greater due diligence.
