Have Bond Managers formally integrated ESG into their investment processes?

November 11, 2015 Categories: Investment, Investment Strategy, Markets


Environmental, Social and Governance (ESG) factors are a hot topic for equity investors.

But for bond investors, there is some uncertainty over how much efficacy ESG factors really have, and whether there is a good way to integrate them. In my role as global Head of Fixed Income research, my core mission is to ensure that the investment management firms on our research ‘buy’ list employ robust investment processes and intelligent execution, and so have a high probability of generating superior investment returns in the future. That means we need to understand how a manager incorporates ESG into their strategy and whether this will positively impact performance going forward. My colleagues recently compiled a survey of 79 leading bond managers from around the globe, to assess how far those managers have formally integrated ESG factors into their methodology. I’d like to share some of those findings and – more importantly – reflect on what they really mean.

ESG in fixed income may appear to be a relatively new concept, but in reality many fixed income strategies already incorporate elements of Environmental, Social and Governance factors. In particular, analysis of governance is frequently very developed. Bond issuers have contractual obligations, and so this analysis can address not only ability, but also willingness, to pay. Assessing the quality of a company’s management is also a critical part of credit analysis which has a direct tie to governance. In an Emerging Markets (EM) context, the strength of a country’s institutions, its political stability and its status in the global community can help an EM debt investor determine whether there is adequate governance to believe that a country will be willing to pay back its debts.

Similarly, bond investors bear the risk of litigation and catastrophic reputational damage overtaking a company, but enjoy none of the profits upside that may attach to socially risky behaviour. That’s why social factors can be important to bond investors too. Increasingly, technology is creating new risks – in terms for instance of climate risk and stranded carbon assets – that will likely be more worrisome to bond investors in future. So environmental factors have garnered further attention also.

It is in this context that we commissioned our survey of fixed income managers. We wanted to understand better how important ESG was to their investment process, how well integrated ESG was within their process and how effective it was.

What were we expecting from our ESG bond manager survey?
We expected that formal ESG integration would be most important and most clearly apparent in higher-risk areas such as EMs and high-yield corporate credits because those markets incur greater credit and country risk, and much less so in areas such as Developed Markets (DM) government and municipal bonds. We recognized that there would be some exceptional cases – for instance, managers with 100% pure quant processes focused on DM government bonds – where formal ESG policies would not necessarily be applicable.

Most importantly, we were very aware that, while ESG awareness may be correlated with good performance, there is not necessarily a causal link, i.e. a good investment may have some level of correlation with strong ESG scores, but achieving strong ESG scores may not be the reason for it being a good investment. The available evidence in Fixed Income is not conclusive to support ESG factor investing as an effective approach in its own right.

Consequently, managers that tick all the ESG boxes may still not have all the skills necessary to generate superior performance. That’s why, although we meaningfully engage with managers about their approach to ESG factors and why we continue to develop our research into the subject, we do not link positive expected performance to more developed ESG processes, or expect that our survey will be a silver bullet for picking outperforming managers.

What did we actually find?
Well, first and foremost, we found a high level of ESG awareness. In their responses, 63% of the respondent managers claimed that both social and environmental factors were already integrated into their investment processes. However only 49% had a formal Responsible Investment Policy that covers how ESG considerations are actually integrated into their investment process. A similar number (48%) said that an ESG factor had overridden an otherwise attractive investment in their investment process. Perhaps unsurprisingly given the variety of managers and methodologies, there was no consensus on how best to implement ESG factors into a decision process.

Secondly, as expected, we found ESG awareness to be most pronounced in the higher-risk areas, and to be much less evident in strategies based on interest rate or global macro themes.

Thirdly, there were many interesting insights, however because the participants often had different perspectives on and definitions of ESG, these insights were not perfectly captured by yes/no answers, which typically tended to understate the true level of ESG awareness in the respondent universe. In particular, a number of respondents appeared to understand the specific terms ‘ESG’ and ‘Responsible Investment’ primarily in terms of their clients’ ethical value judgements, rather than in terms of investment fundamentals (“values” rather than “value”). These managers’ responses indicated that a formal ESG or Responsible Investment policy was the prerogative of their clients, and that their own management role was to work to implement their clients’ briefs; for that reason they had declined to adopt a formal ESG policy themselves. Nonetheless, these respondent managers are highly capable firms and in fact evaluate many ESG factors as a matter of course.

Other respondent managers specifically stressed that they understood ESG primarily in terms of investment fundamentals and as central to their investment judgements. So to get a fuller understanding of the managers’ mind-sets, you really need to read the more detailed summary of the survey here (Russell Investments Bond Manager ESG Survey 2015) which includes direct quotations from some of the respondent managers and some supplementary comments in which we endeavour to ‘read between the lines’ of their answers.

I hope you find it interesting reading, but in closing I’d like to stress that the route to outstanding manager performance is principally through a robust process and intelligent execution – where ESG factors can be a complementary input.

Adam Smears, Head of Fixed Income Research, Investment Division




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