[This article appears in our March 2018 issue of ETF Report.]
Income investors who wanted to use fixed-income exchange-traded funds that included environmental, social or governance criteria have had few options—until now.
In the past several months, several fund issuers such as Nuveen, iShares and Sage Advisory have launched fixed-income ESG ETFs, finally offering financial advisors and their clients a way to apply ESG criteria to their whole portfolio.
What’s held issuers back until now was a lack of robust data to create debt-focused ESG indexes and ETFs, says Martin Kremenstein, head of ETFs at Nuveen Investments. Data for equity ESG ETFs are widely available, as equity exchanges have clear reporting requirements, making it easier to confirm if a company meets ESG criteria. That’s not the case for bonds.
Nuveen’s fixed-income ESG ETF, the Nushares ESG U.S. Aggregate Bond ETF (NUBD), which debuted in September 2017, follows the Bloomberg Barclays MSCI US Aggregate ESG Select Index. At $41.8 million in assets under management, it’s the largest ETF in its category. It has an expense ratio of 20 basis points.
Because fixed-income ESG data aren’t as robust as on the equity side, Kremenstein says Nuveen made some tweaks to the holdings based on the recommendation of their responsible investing team. To ensure the fund had a low-carbon footprint, NUBD excludes issuers in sectors having high levels of fossil-fuel reserve ownership—which includes metals miners and oil and gas producers. Additionally, agency-backed and mortgage-backed securities are included without ESG rankings.
Work In Progress
Nuveen decided to remove entire sectors from the fund, as it’s still difficult to trace fossil-fuel reserve ownership back to the corporate owner, he says. As more data become available, Kremenstein adds that Nuveen can update its low-carbon screen to target companies, not sectors.
ESG criteria isn’t enforced on ABS and MBS debt, since no one is screening for ESG on those securities, he notes: “We could have not included those in the fund, but our [intent] is to take the benchmarks and produce a working ESG version to the best of our ability.”
Building a fixed-income ESG ETF is different than an equity ESG ETF, says Scott Kubie, chief investment officer at Carson Wealth Group. One of the reasons his firm uses the iShares ESG USD Corporate Bond (SUSC) and the iShares ESG 1-5 Year USD Corporate Bond (SUSB) is that BlackRock thought about the ESG strategy from a fixed-income perspective, he says. Carson Wealth didn’t want an issuer to take ESG equity choices “and stick them in a set of bond options that really didn’t align with the overall purpose,” Kubie said.
SUSC has $10 million in AUM and charges 18 basis points, while SUSB has $24 million in AUM and charges 12 basis points.
When deciding on the fixed-income ESG ETFs, duration and credit quality are both factors to consider, Kubie notes. Because the ESG screens usually means higher-quality companies, he thinks the corporate debt issuance included in SUSC and SUSB may be at less risk for default.
“If you like ESG for equities, you should like it for bonds as well,” he said.
Andy Hart, president and chief advisor of Delegate Advisors, says he’s pleased to see these funds launched and that he’s had at least one client express interest. Before they invest, he says they’re in a “wait-and-see mode” to ensure the other core elements of underlying liquidity, quality and duration are a right fit for clients.
Laurie Kamhi, managing director of LCK Wealth Management at HighTower, says at this point these funds wouldn’t meet the liquidity criteria they have for their clients. But she notes that having the big fund issuers seed these funds to see if there’s demand is really important, because people use bonds for safety.
“I’m a little skeptical at this early stage that you need the [fixed-income] ETF to be purely ESG-focused. I think you can have pressure on companies to use that ESG criteria and ratings across their whole portfolio. And we’re seeing that. [BlackRock Chief Executive Officer] Larry Fink made that announcement,” she said, referring to Fink’s letter to CEOs saying BlackRock will use ESG criteria as they consider investments and proxy votes in equity stakes.
Kamhi says she wants to watch how these funds perform, as the credit cycle seems to be changing, which will have an impact on all fixed-income investments—ESG or not.
Not all of these fixed-income funds take the same approach to ESG. The VanEck Vectors Green Bond (GRNB), which has $13.6 million in AUM and a 40-basis point expense ratio, invests in global bonds issued to finance “green” projects—primarily solar, wind and low-carbon construction certified by the Climate Bonds Initiative, a London-based nongovernment organization.
However, some ESG purists take issue with “green” bonds, as any company can issue a green bond for a targeted project while not following ESG principles for the rest of its business dealings.
Advocacy by ESG fund managers to convince companies to do good has become a bigger part of the movement. On the equity side, some funds add “best of the worst” companies to encourage better corporate behavior via proxy voting, such as prodding energy companies to produce more renewable energy.
Sage Advisory Services is taking an advocacy approach with its Sage ESG Intermediate Credit ETF (GUDB), a fund with $9.8 million in AUM and an expense ratio of 35 basis points. Robert Smith, president and chief investment officer at Sage, said it worked with Sustainalytics to create its ESG criteria, and include some “best of the worst” holdings to encourage positive changes at the companies. Two examples are bonds from DTE Energy and Exelon, both of which use natural gas and nuclear power.
Although bondholders can’t vote on proxy resolutions, Smith says they still can have an influence on company behavior to consider ESG criteria when they buy newly issued bonds: “They do have a tremendous amount of impact in regard to not only how the deals are structured, but really what management is doing with the proceeds and how they’re investing those proceeds.”