[This article appears in our March 2019 issue of ETF Report.]
Amy O’Brien, Martin Kremenstein, Jordan Farris
Fixed-income exchange-traded funds are a relatively new animal in the ETF world, and within environmental, social and governance strategies, debt ETFs are even rarer.
One of the few bond ESG ETFs is the Nuveen ESG U.S. Aggregate Bond ETF (NUBD), launched in September 2017, giving the fund a little over a one-year track record. The expense ratio is 20 basis points and it has $51 million in assets under management. It’s the first ESG bond fund from the company, with more fixed-income funds expected.
NUBD draws its holdings from the Bloomberg Barclays U.S. Aggregate Bond Index, but shakes up the index by screening and weighting based on socially responsible criteria, relative to industry peers, as determined by MSCI.
That composition makes NUBD a potential core holding for an ESG portfolio, complementing Nuveen’s seven ESG equity holdings. But Martin Kremenstein, head of retirement products and ETFs at Nuveen, says creating an ESG fixed-income fund was more difficult than the equity offerings.
“It’s a little harder to do [it] with bonds, because you don’t have the granular data [you do with equities],” he says.
Carbon Footprint & Bonds
Regarding methodology, Jordan Farris, head of ETF product development for Nuveen, says they worked closely with Nuveen’s responsible investing team, as well as MSCI and Bloomberg Barclays, to create a product that would offer investors the same risk/return profile as a standard aggregate bond index, but that would increase the ESG score and reduce the carbon footprint.
Just as they do for their socially responsible equity ETFs, Nuveen selected companies with high ESG scores and low controversy scores, screening out the usual suspects such as weapons manufacturers and companies involved in alcohol and tobacco. They also ranked holdings to lower the carbon footprint.
“There is a slight difference in the methodology for our fixed-income ETFs as compared to the equity products,” said Farris, “and that’s due to the fact that you can’t map carbon emissions data to an individual bond.”
He says they reduced the carbon footprint by excluding sectors with very high levels of fossil-fuel ownership: independent energy companies, integrated energy companies, and metals and mining companies. NUBD’s current carbon footprint versus the Bloomberg Barclays Agg is one-third lower while still managing to track the index’s risk/return characteristics.
Nuveen overlays a low-carbon footprint focus across products to differentiate itself from other socially responsible ETF issuers, Kremenstein says.
“You can tell them ESG scores are up by 20%, but for a lot of people that’s a little meaningless. We have a very material carbon footprint reduction, from 40% to 60% across the suite, I believe, and that resonates with the end investor,” he says.
To celebrate its first birthday, NUBD slightly outperformed the Bloomberg Barclays U.S. Aggregate Bond Index, with a one-year annualized return up 0.93% and the Agg up 0.79%. Still, Kremenstein says, “It’s nothing to write home about.”
He cautions against putting too much emphasis on NUBD possibly delivering outperformance versus the Agg because so much of its holdings are the same, with U.S. Treasurys and agency debt comprising half of the fund.
Still, in a year where the energy sector did poorly, having a low-carbon portfolio helped Nuveen’s equity ETFs shine. Kremenstein says Nuveen’s ESG methodology stood out particularly in its value-oriented ETFs.
The Nuveen ESG Small-Cap ETF (NUSC), was among the top-performing 6% of small-cap blend funds over the last two years, according to Morningstar, including against actively managed funds. The Nuveen ESG Large-Cap Value ETF (NULV) and the Nuveen ESG Mid-Cap Value ETF (NUMV) were both in the top quartile in their category versus actively managed funds and index ETFs.
For a larger view, please click on the image above.
“We’re seeing persistent value-add from pairing ESG with value in particular,” Kremenstein noted.
For growth funds, the alpha from the ESG factor is more cyclical, he says. In 2018, Nuveen had strong comparative returns in the Nuveen ESG Large-Cap Growth ETF (NULG). Part of that was because it was light on FAANG stocks—Facebook, Amazon, Apple, Netflix and Google. NULG didn’t have any Facebook holdings, and in the November rebalance, Apple dropped out. Kremenstein says this performance makes sense for growth portfolios.
“A lot of the times, stocks that go supernova don’t always go very high on the ESG scores,” he explained. “So sometimes you miss a bit of that upside, but on the other side of it, you’re going to miss it whenever they flame out.”
Deep ESG Roots
Amy O’Brien, head of responsible investing at Nuveen, says the firm’s responsible investing approach has its roots in TIAA, Nuveen’s parent company, whose philosophy goes back nearly five decades. Nuveen’s parent firm’s involvement in the business case behind social issues means ESG investing isn’t just a product line.
“The mandate for my team is really to drive this holistic framework across all of Nuveen,” O’Brien said. “This means working in partnership with portfolio managers and analysts. It’s not doing the work for them; it’s doing the work with them.”
The responsible investing team not only offers specialized expertise on research and data, but also client expectations, when it comes to ESG funds.
“People generally aren’t looking at these topics in black and white,” she noted. “They know there’s a middle ground, and we brought that observation to how we built out the index upon which the ETFs are based.”
Socially responsible investor demand is growing, albeit from a low base, and remains a small part of the total ETF market. Overall, ESG ETF assets under management rose from 63% over a year ago to $7.9 billion versus the $3.5 trillion invested in the ETF industry.
Kremenstein says 2019 has seen a good start in terms of flow for the ESG products: “The amount of reverse inquiry we’re getting from clients is phenomenal. We think the investment advisors now understand why. Really it’s a question of showing them how, which is why we’ve moved very aggressively into portfolio implementation and helping advisors build the portfolio.”
Coming Into Their Own
The equity products will celebrate three years at the end of 2019. If the strong performance continues, that’ll attract further interest. He understands the skepticism that investors might have with ESG: They don’t want promises that a theme adds value, they want to see that it does.
Early socially responsible ETFs overall “weren’t very good,” Kremenstein says, but the improvements in methods, techniques and data demonstrate ESG can generate alpha: “We just have to show the marketplace we can deliver value without compromising the core ESG methodology.”
In addition to NUBD, Nuveen has plans for other bond funds, but couldn’t speak directly on future offerings. But the longer-term plan, he says, is to build out a robust platform that incorporates ESG.
“We want ESG investors to have the same choice of asset classes and strategies that non-ESG investors have,” Kremenstein said. “We don’t need to have 19 different types of multifactor large-cap strategy like you have in the non-ESG space. But we want the ESG investor to not have to compromise their asset allocation to remain aligned with their ESG mandate.”