Last year saw assets under management in sustainable fixed income ETFs triple from USD7.6 billion at the end of 2019 to USD21.2 billion by the end of 20201, and this growth is something that Cara Milton-Edwards, Fixed income product strategist, iShares EMEA believes will accelerate over the next five years.
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Last year saw assets under management in sustainable fixed income ETFs triple from USD7.6 billion at the end of 2019 to USD21.2 billion by the end of 20201, and this growth is something that Cara Milton-Edwards (pictured), Fixed income product strategist, iShares EMEA believes will accelerate over the next five years.
However, investors keen to add sustainability into their portfolios face a number of challenges, she says, and Covid 19 definitely spotlighted those challenges. “We saw investors who had over stretched for yield, leaving them with poor diversification,” she says. “Also, their performance was at the mercy of currency fluctuations and they lacked liquidity when it was most needed.”
Now she finds that investors are taking a more holistic approach when utilising fixed income ETFs to drive the efficiencies in their portfolios. “In particular, sustainable index exposures allow investors to achieve clarity, transparency and nimbleness through the ETF wrapper and they can easily incorporate sustainability and we see that through the iShares range of sustainable fixed income ETFs,” she says.
Growth is primarily coming from three places, according to Milton-Edwards: firstly, from investors switching from non ESG to ESG. “This helps improve the sustainability profile of investments and that is where we see the bulk of asset growth today,” she says. “Secondly, we find that investors select thematically, through one consideration, for example, focusing on climate change, and thirdly, investors are seeking an impact investment approach, such as green bonds.”
iShares is the leader in sustainable fixed income investing with USD18.9 billion of assets globally, and indexed green bonds are USD3.5 billion within that asset base2. “We have seen the green bonds constituent growing and we also cover every fixed income asset class,” Milton-Edwards says, citing indexed sustainable solutions in investment grade, high yield, different currencies and also along different parts of the yield curve.
“The range of ETFs and index mutual fund wrappers has grown in order for investors to be able to build fixed income sustainable portfolios using a rules-based approach,” she says.
The switching from non-ESG to ESG is a phenomenon that is led by institutional investors in the first case, she says. “I also think the demand comes from end investors, particularly for retail investors.” She notes that recent regulatory requirements for European fund managers under the Sustainable Finance Disclosure Regulation (SFDR) is also driving growth and greater transparency which is accelerating the trend. “The trend is global but it is led by Europe,” Milton-Edwards says. “In the context of indexed fixed income, ETF growth has historically come from the US, but sustainable investing has flipped that with Europe leading the way in terms of the number of products, the style of sustainable investing and the assets under management.
In years gone by, investors incorporating ethics or green filters through their portfolios suffered loss of investment return but now things are very different. Milton-Edwards says: “when incorporating sustainable fixed income into portfolios, we have to consider the impact on returns. They are still driven by standard fixed income factors such as liquidity or credit quality.”
Four criteria dominate the move to incorporate sustainability into a fixed income portfolio. Firstly, an improved sustainable profile, which can be asset class specific, so investment grade bonds are subjected to two metrics. The first is the ESG score of the issuer and the second is the carbon emissions of an issuer.
Secondly, sustainable indexed fixed income offers investors greater resiliency during periods of risk off than non-sustainable indices. Here, the team has observed that during the market sell off of February and March in 2020, sustainable exposures experienced less draw down than their non-sustainable equivalents.
The third factor is that sustainable index exposures offer investments similar or lower volatility during risk on and risk off periods. “When markets get volatile, sustainable exposures can offer lower volatility compared with their comparative indices,” Milton-Edwards says. “And, finally, and obviously very important to investors, is the fact that they don’t have to pay more for sustainable exposures – they can incorporate sustainable exposures at the same cost.”
She notes that during risk on periods, it’s important to understand what fixed income factors are driving performance. “these exposures tend to have a tilt towards higher quality credit,” she says. “And in risk off periods, there are performance differentials as a result. Our expectation is that the market will start to incorporate sustainability as they price bonds.”
Incorporating sustainability into fixed income portfolios is not a one-size-fits-all activity, Milton-Edwards says. “It is important to start at an asset class level, taking the beta of the asset class you are trying to access into consideration. We incorporate sustainability in ways that are reflective of the sustainability characteristics of each asset class so with investment grade corporate bonds, we use business and ESG screens.”
She comments that the same approach does not work as well within government bonds for two reasons. Firstly, the ESG rating of government bonds, particularly in the developed markets, tend to have high scores therefore from an indexing perspective it can be hard to create a solution that has a sustainable profile improvement in comparison to the starting universe.
Secondly, “When you look under the hood of those ESG ratings, what we see is very little consensus or agreement of what should be going into those social or governance pillars.”
From a sovereign perspective, they tend to be quite political in nature, with the sheer number of key performance indicators spread from education to access to fresh water or the level of democracy.
“There is consensus that sovereign’s face climate risk and will be negatively impacted by climate risk but sovereigns are also a key source of funding for transition to low carbon economies, and the 2016 Paris accord has given those alignment opportunities,” she says.
She comments that iShares offers a range of approaches and works closely with investors on building solutions. “We think about how best to achieve that outcome with our own fixed income indexing expertise,” she says.
1,2 Source: BlackRock, 31 May 2021.
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