This commentary is written by Martin Fridson, a high-yield market veteran who is chief investment officer of Lehmann Livian Fridson Advisors LLC, as well as a contributing analyst to S&P Global Market Intelligence.
As part of our recent exploration of the impact of environmental, social, and governance principles on the high-yield market, we surveyed managers on their responses to clients' expressed interest in ESG-minded investing. We did not attempt to query the entire universe of U.S. high-yield managers. Not every manager that we queried replied and some responses were not for attribution. Nevertheless, comments from the handful of companies mentioned in this article should provide readers with a feel for the current state of play.
The ESG backdrop
Henry Shilling of Sustainable Investing provided useful background for this project. He reported that from the beginning of 2019 to June 2020, sustainable high-yield corporate and municipal mutual funds grew by 26 times, versus 6.6 times for overall sustainable funds. Over that span, ESG-related assets under management in those categories skyrocketed from $1.7 billion to $46.3 billion. The number of ESG-based high-yield funds mushroomed from seven to 43, with the number of firms offering such products increasing from seven to 24 (note 1).
Shilling noted, however, that this dramatic growth resulted largely from the rebranding of existing funds in conjunction with amending fund prospectuses to reflect the adoption of sustainable investing strategies. As he further noted, the high-yield ESG segment is dominated by funds stating only that they may consider ESG factors in investment decisions. That is a less emphatic pledge than explicitly committing to do so.
The predominance (67% of AUM) among high-yield funds of this approach, which Shilling labels "ESG Integration-Consideration," contrasts with the ascendancy of "ESG Integration" in ESG management as a whole. In the latter mode of operation, ESG factors and risk are systematically analyzed and influence buy/hold/sell decisions when they are judged both relevant and material to long-term performance. A third approach represented among the top 10 sustainable high-yield mutual fund and ETF managers (by a single firm) is "Exclusions." This investment process places certain companies or sectors off-limits on the grounds of specific objections to involvement with such things as gambling, tobacco, fossil fuels and child labor.
All current sustainable high-yield fund assets are actively managed except for the NuShares ETF Trust - Nuveen ESG High Yield Corporate Bond ETF, discussed below. As of the date of Shilling's report, that fund accounted for just 0.1% of high-yield ESG AUM, versus a 2% ratio of passive-to-total assets for high-yield ESG management as a whole. The only other ETF in the high-yield group is the actively managed JPMorgan High Yield Research Enhanced ETF.
Also, by way of ESG background, the Principles for Responsible Investment, or PRI, judges asset managers' application of ESG with a scorecard. The PRI is a United Nations-supported global network of investors working together to implement its six aspirational principles. The PRI scorecard contains a module for each of the rated firm's investment categories. In each module, the manager receives a score of A+, A, B, C, D or E, which is provided along with the median score of all companies rated in the category. Additionally, major investment consultants have created their own committees on ESG or impact investing.
High-yield managers' responses to demand for ESG investing
Some managers that we queried characterized investor interest in ESG as an import from Europe. They reported that it is now unquestionably a force to be reckoned with in global high-yield funds and is gaining traction among investors focused on the United States. One high-yield mutual manager reported never yet having received an ESG-related inquiry from a fund shareholder or financial adviser. Those constituencies, the manager suggested, remain exclusively focused on returns. Nevertheless, the fund's parent firm tracks its portfolio managers' holdings and sends them periodic reports of their ESG scores, with discussion.
Another portfolio manager's comments had a skeptical tone. The vagueness of current ESG ratings, the manager said, constitutes an obstacle to compliance-testing and comparative performance measurement.
Taking a more constructive view, the Shenkman Capital Management, or SCM, website states that the firm has tailored portfolios to client-specific sustainable, responsible and impact investing, or SRI, objectives since 2002. SCM recently became a PRI signatory and has worked toward systematizing its ESG process throughout the firm. SCM does not treat ESG factors on a stand-alone basis, but integrates them into its structured investment process, assigning ESG scores to companies in its portfolios.
SCM's director of ESG, Amy Levine, explained that while governance has always been integral to the firm's credit analysis, social issues have grown in importance in recent times. In SCM's view, factors such as worker health and safety and workforce diversity have a bearing on companies' ability to retain the best employees. Formerly, clients provided restricted lists of categories such as tobacco, private prisons, single-use plastic and controversial weapons. SCM now provides such a list to its clients.
A Payden & Rygel spokesperson noted particularly strong interest from Dutch pension plan sponsors in requiring an ESG-conscious investment process or establishing hard rules on what the firm should or should not own. Less prevalent at this point, but growing, are impact-investing requirements. Payden & Rygel maintains client-specific investment guidelines. They have long since dealt with exclusions such as tobacco and energy, but increasingly involve such things as minimum environmental scores. The firm proactively updates investment consultants' ESG committees on its efforts.
Payden & Rygel further stated that meeting investor demand for a thorough analysis of ESG considerations has been frustrated by a lack of consistency and comparability in ESG data. The firm has consequently found great value in the industry-specific standards established by the Sustainability Accounting Standards Board, or SASB. In contrast to other available ESG scores that rely on the volume of disclosure, Payden & Rygel contends, the SASB standards provide insights into material ESG factors that may enhance or diminish an issuer's ability to repay debt. For emerging markets credits, the firm employs a proprietary country ESG scoring system.
Federated Hermes emphasizes the role of ESG risk evaluation within its high-yield credit research as a means of uncovering potential sources of tail risk. Traditional fundamental analysis, the firm's website states, would not identify companies at high risk of small-probability/large-price-impact events such as oil spills, data breaches and safety violations. Federated Hermes also notes that the high-yield market presents special challenges for ESG investing due to many issuers' small size and, in some cases, private ownership. Lack of robust disclosure by such companies, says the firm, limits the usefulness of third-party ESG ratings and places a premium on first-hand credit analysis.
To address its concern about third-party ratings, Federated Hermes' analysts discuss with management the ESG risks most pertinent to the company and its industry. For each company the firm invests in, it generates a proprietary DESG score. The D stands for debtholder stewardship.
Nuveen, too, assigns proprietary ESG ratings to high-yield issuers. Its responsible investing team provides industry-specific training on 35 separate ESG topics. Within their industry coverage universes, credit analysts rank companies on an ESG scale of leader, neutral or laggard.
Evidence on impact of ESG scoring
As noted above, the present array of high-yield ESG investment vehicles includes one passively managed offering, the Nuveen ESG High Yield Corporate Bond ETF. It seeks to track the performance of the Bloomberg Barclays MSCI US High Yield Very Liquid ESG Select Index. Another passively managed vehicle, the iShares iBoxx High Yield Corporate Bond ETF seeks to produce investment results that correspond to the price and yield of the Bloomberg Barclays MSCI High Yield Very Liquid Bond Index. The coexistence of these two ETFs makes possible a fairly direct comparison of ESG-focused and non-ESG-focused high-yield returns with actual assets, as opposed to the indexes analyzed in the studies listed in note 1, below.
Nuveen's ESG ETF has a short history, beginning only in October 2019. The table below nevertheless provides some insight into ESG-focused high-yield investment. In the 10 months since inception, the passive ESG ETF outperformed the conventional ETF, 2.57% to 2.03%.
The small number of observations and the large variance renders it impossible to establish a statistically significant difference between the monthly mean returns of 0.15% for ESG ETF and 0.08% for the ALL HY ETF. Furthermore, the comparative returns are inconsistent, with the ESG outperforming in just six out of 10 months, barely better than a 50/50 split.
The ESG ETF did have a clear edge, however, in the five months in which the ICE BofA US High Yield Index's price return (not its total return) was negative, as indicated by shading in the table above. Note, however, that in all five of the negative-price-return months, the ESG ETF was helped by having a lower concentration, vis-à-vis the ALL HY ETF, in the Energy industry. (See table below and note 2.)
Granted, if fossil fuel producers wind up producing inferior risk-adjusted returns over the long run, the ESG HY ETF's de-emphasis of those companies will prove a bona fide performance benefit. At this point, however, we have no clear evidence that energy's recent underperformance is a consequence of its unfavorable environmental characteristics.
An investor could obtain the same benefit that the ESG HY ETF got by choosing to underweight or avoid energy based solely on a belief that it faces chronic oversupply conditions. Such an investor would not have to accept all the other, potentially return-reducing constraints of following an ESG-based investment regimen. Those constraints on investment choices may be quite consequential, as suggested by the ESG ETF's comparatively high concentration in its top 10 holdings (18.87%), four times that of the ALL HY ETF (4.56%).
Clearly, the comparative returns of the ESG ETF and the ALL HY ETF were affected by a lot more than the portfolio profiles shown in the table just above. For instance, the ESG ETF should have been disadvantaged by its lower Energy concentration in May, when the ICE BofA US High Yield Energy Index walloped the ICE BofA US High Yield Index, 12.73% to 4.57%. Despite that handicap, however, the ESG ETF outperformed the ALL HY ETF, 4.77% to 3.51% in that month. It was not a matter of the ESG ETF triumphing by virtue of its somewhat lower concentration in debt rated CCC or lower. During May, the ICE BofA CCC & Lower US High Yield Index beat the ICE BofA US High Yield Index, 5.85% to 4.57%. Conversely, the ESG ETF's higher overweighting in BBs, relative to the ALL HY ETF, should have hurt it in May, since the ICE BofA BB US High Yield Index underperformed the all-ratings index, 3.77% to 4.57%.
These hints that issue-specific factors played a significant role offer optimists some ground for hoping that as a longer performance history accumulates, ESG-tilted high-yield portfolios will genuinely produce superior risk-adjusted returns. In short, high-minded investors' dream of doing well by doing good may be fulfilled. It would be premature to make such a claim at present, however. By the same token, one cannot prove from the current data available that adhering to an ESG-conscious investment policy imposes a financial penalty.
Research assistance by Lu Jiang and Zhiyuan Mei. Additional research assistance by Daniel Navaei.
ICE BofA Index System data is used by permission. Copyright © 2020 ICE Data Services. The use of the above in no way implies that ICE Data Services or any of its affiliates endorses the views or interpretation or the use of such information or acts as any endorsement of Lehmann, Livian, Fridson Advisors, LLC's use of such information. The information is provided "as is," and none of ICE Data Services or any of its affiliates warrants the accuracy or completeness of the information.
1. Henry Shilling, "High yield sustainable corporate and municipal bond funds and ETFs," Sustainable Investing, August 2020.
2. Bloomberg does not show the ESG ETF's concentration in energy, but we know that it is less than that of the smallest industry concentration reported.