Despite undeniable demand, wider adoption sustainable bond ETFs faces crucial challenges
Given the gusts of demand and performance that have blown behind ESG this year, it might feel like it’s just a matter of time before the trend can replicate its equity-market success and find its way into fixed-income ETFs. But as of now, it looks like investors hungry for sustainable bond ETF strategies still have a long wait ahead.
Citing data from the Index Industry Association, an article by ETF Stream notes that fixed-income ESG indices have accounted for much of the 40% surge in the overall number of ESG indices that have occurred over the past year. That comes alongside findings by Tabula Investment Management, where 82% of professional investors expressed a desire for innovation within fixed-income ESG ETFs.
And while the sustainable fixed-income space is still in its early days – Morningstar’s Global Passive ESG Landscape 2020 counts just 9% of sustainable index assets sitting in fixed-income funds across the world – there is evidence of growth. Based on data from TrackInsight, there have been 27 new fixed-income ESG ETFs launched this year as of October 19 in Europe, accounting for nearly half of the 66 fixed-income ESG ETFs that are available in the region currently.
What stands in the way of broader development and adoption? One major challenge relates to engagement, where critics say passive funds fall short because of their largely hands-off relationship with portfolio companies. The situation is doubly difficult for fixed-income investors, said Carmen Nuzzo, head of fixed income at the Principles for Responsible Investing (PRI), who told ETF Stream: “It is harder for bond holders to engage than it is for shareholders as they don’t have institutionalised channels or voting rights.”
And while bond investors might be able to influence the construction of ESG indices, Nuzzo said the sprawling growth of index providers with no uniform system for ESG scoring makes it a taxing exercise.
Another sticking point emerges when it comes to sovereign debt. As noted by Morningstar, corporate bonds lend themselves well to ESG scoring systems similar to equities, but evaluating government debt can be a tricky affair as one risks crossing the line between objective ESG assessment and political decision-making.
“Some ESG-conscious investors may consider some of the policies of the current US administration – like the withdrawal from the Paris Climate Agreement – to go against the most basic of ESG principles,” Morningstar said. “One must seriously consider, though, the implications of excluding the largest developed government bond market in the world from a bond fund.”
The ESG wave hasn’t exactly washed over the emerging market debt space, either. As per TrackInsight, just one fixed-income ESG ETF focused on emerging markets has been launched this year, and none have any allocations to China despite its strategic significance.
The China problem, explained Anaëlle Ubaldino, head of quant advisory at Koris International, stems from the fact that data from the region is difficult to access. “[P]roviders of indices cannot efficiently create a fixed income ESG index of Chinese bonds if they don’t have the ESG metrics at a company level,” she said.
But there could be progress on the front soon. Ubaldino said China has committed to making the nearly 4,000 corporates listed in the country publish ESG metrics by year’s end. If successful, the significantly improved data availability could trigger a burst of product development.
“We are definitely going to see some development in this area as soon as product providers have the underlying data to start developing products,” Ubaldino said.