How Advisors Use ESG Bond ETFs

As environmental, social and governance (ESG) investing has taken off, investors have been increasingly seeking ways to invest their values across their entire portfolios, not just the equity portion.

Currently, though, ESG pickings among bond ETFs remain slim. There are only nine fixed income ETFs that FactSet categorizes as socially responsible, with a handful of other thematic funds that arguably also fit the bill.

That hasn't stopped advisors from making it work, however. ETF.com spoke with several advisors who use socially responsible and ESG investments for their clients to see how they approach their fixed income allocations. Here’s what they had to say:

ETF.com: Why do you use ESG bond ETFs for your clients?

MAYA PHILIPSON, Principal, Robasciotti & Philipson: We embraced fixed income ETFs because the units for individual fixed income purchases are so high that it's really difficult to get into a proper asset allocation unless your client has multimillions of dollars. You can purchase stocks for $10 or maybe $100/share, but a bond starts at maybe $1,000 and goes up to $10,000.

We like fixed income ETFs for ESG investments, specifically, because we can do more targeted investments. Equity funds use more exclusionary screening: They screen out companies that make weapons, tobacco, private prisons. In the fixed income space, we can actually support companies, municipalities, programs that are more in line with the values of our clients. It's more proactive.

SCOTT ARNOLD, Partner & portfolio manager, IMPACTfolio: We view ESG integration as part of our fiduciary duty to improve the risk/return characteristics of a portfolio. There's an MSCI study from 2017 that looked at high ESG-rated versus lower ESG-rated companies, and the bottom line was, even if you didn't care about the environmental or social benefits of ESG investing, it's just a great way to reduce risk for both equities and fixed income.

Companies with high ESG ratings tend to have less risk, and their cost of capital is lower. That helps them have higher cash flow, which then can lead to higher ratings from the various [credit] rating agencies. That helps make the company more profitable and reduces the chance of a downgrade or default in the future. It's a positive feedback loop.

ETF.com: Which specific ESG bond ETFs do you use?

JOHANN KLAASSEN, EVP & CIO, Horizons Sustainable Financial Services: We use GRNB [the VanEck Vectors Green Bond ETF], NUBD [the Nuveen ESG U.S. Aggregate Bond ETF], the Sage ESG Intermediate Credit ETF (GUDB) and the Invesco Taxable Municipal Bond ETF (BAB).

BAB used to track Build America Bonds [author's note: Build America Bonds were a special category of taxable municipal bond issued in the wake of the 2008-09 financial crisis], but they never really caught on, so [Invesco] switched the fund's focus. The concept was very good; Build America Bonds were designed with green, community-building plans in mind. As far as I can tell, BAB is still doing the same kind of work, just without the Build America Bond labeling.

Arnold: 100% of our fixed income allocation is split among various ESG ETFs. We're big fans of the NuShares line of ETFs.

For example, we really like NUBD. The risk/return characteristics of NUBD are almost identical to AGG [the iShares Core U.S. Aggregate Bond ETF] or BND [the Vanguard Total Bond Market ETF], so an advisory firm using those funds could substitute some of that current broad exposure with the Nuveen equivalent. You won't give up any performance, but you're starting to align the portfolio better with your firm's or your clients’ values. You're also reducing portfolio risk.

Philipson: One of the ESG ETFs I use is the PIMCO Intermediate Municipal Bond Active ETF (MUNI). It's not marketed as an ESG ETF, per se. But when I started looking at the holdings, I realized it met my stringent criteria for “socially responsible investing.” I could actually purchase a nonmarketed ESG index fund that would get me the same thing as one of those marketed ESG funds, but for much cheaper.

ETF.com: What types of ESG bond ETFs would you like to see that don't yet exist?

Philipson: We want more ESG ETFs that—instead of slavishly following an index—are more themed, which could allow us to more proactively place our clients' dollars into market segments they care about. Also, we use a lot of municipal bond ETFs, so I'd love to see an ESG-screened municipal bond ETF.

Arnold: If we could wave that magic wand to have any ESG-specific ETF, it would be in the multisector bond category. Nuveen did just roll out a high yield ETF [the Nuveen ESG High Yield Corporate Bond ETF (NUHY)], which we were excited to see. But we'd like to see something like the PIMCO Income Fund (PIMIX) or the Loomis Sayles Bond Fund (LSBDX), just as an ESG equivalent.

Klaassen: I'd like to see more bond ETFs that actually actively take a socially responsible screening approach, rather than the ESG overweight/underweight or best-in-class approach. I have a lot of clients with a very strict sense of what they want to own. They don't want, say, Exxon in their portfolios, even as an underweight.

ETF.com: What steps do you take to avoid "greenwashed" investments, or investments that are ESG in name only?

Klaassen: That's something you have to be cautious about. Sometimes funds are flagged as ESG that aren't doing quite what our clients might like. For example, take GUDB. I had a long conversation with the portfolio manager of that fund about some of the oil company debt in its portfolio. I asked him, "why are those in there?" His answer was because it's good credit; they're good bonds. The manager's take on ESG is to overweight the good actors and underweight the low scorers—not exclude them, just underweight them. Nuveen does the same thing.

But one of the key things our clients want from us is an environmental sustainability focus. The vast majority of our clients do not expect to see Exxon-Mobil (XOM) in their portfolios. So, I have to be cautious about which model portfolios I use GUDB or NUBD for. You just have to be careful about how you're building your ESG portfolio, because there's a lot of nuance. And there are things you can do with individual securities that you just can't do with ETFs.

Philipson: Because our SRI criteria is so strict, I also started looking at the actual sponsors of ETFs, as well. I looked at how they behave.

For example, when I was digging into municipal bond ETFs, my first pick was a Vanguard municipal bond. Generally, I like Vanguard; they're very index-based, which I like, and they're inexpensive. But when I started digging into it, I found Vanguard is one of the largest shareholders of CoreCivic (CXW), a private prison company.

It's not Vanguard's fault, per se, since they're using the index-based approach. But when I create portfolios for my clients, we exclude everything that has to do with private prisons. We hate private prisons.

So, I went with PIMCO; because, as they only do fixed income strategies, they don't own any CoreCivic stock. I'm actively choosing not to give my money to Vanguard, even though I like their product, because I don't want to support their corporate behavior of investing their clients' money in CoreCivic.

The way we think about it is this: Money is a force, a power in the world. Capital creates more things. What do we want to create more of? And what do we want to starve capital from, and hopefully create less of? My clients and I do not want to create more for-profit incarceration of human beings. Any little action I can take that makes it harder to profit off of that, I'm going to do it.

ETF.com: What advice would you give an investor new to ESG investing?

Arnold: "Don't let perfect get in the way of doing good." There's always going to be one part of a portfolio that a client may dislike for one reason or another. Maybe they don't want fossil fuel stocks, or maybe they don't want to invest in Treasuries.

Ultimately, the way we cover that is transparency. We let our clients know that we follow a best-in-class approach to investing, where we try to overweight good players and underweight bad players.

Ultimately, you can avoid those things completely, if you create very ultra-customized portfolios, but there are always trade-offs. You may not be able to build out as well-diversified a portfolio, or you may throw off the risk/return metrics.

Philipson: The amount of greenwashing in this space really bothers me. There are ETF sponsors out there that are just sort of slapdash labeling something as SRI or ESG, though it happens more in the equity space than in fixed income.

I would encourage your readers to truly look at the holdings and methodologies. Don't trust sponsors that are just saying, “We've got Sustainalytics or MSCI data.” You need to know your ETF's holdings, because they're your holdings and your clients' holdings, as well.

Contact Lara Crigger at [email protected]