By Lydia Hamill, Senior Associate, Fixed Income & Multi-Asset Index Product and Michael Hampden-Turner, Director, Fixed Income and Multi-Asset Applied Research
Historically investors have associated ESG investments with reduced performance and assume that increased demand for such assets means paying a premium for them or at least being less fussy about returns.
This is exacerbated by the current macro backdrop. In a fixed income friendly, low-default, low-yield, QE world, there are no real penalties associated with non-ESG status. Borrowing costs might be slightly higher but not enough to result in a business impairment and industries such as coal and oil are still required in the energy complex even if their future potential is increasingly capped. However, higher yielding Emerging Market sovereigns, in which these risks are more existential, may see a higher correlation between better financial outcomes and ESG investment decisions. As is often the case with fixed income, the advantage is less pronounced on the upside and more self-evident on the downside.
We have written on this subject before: there is a statistically significant inverse relationship between Beyond Ratings’ ESG scores and CDS spreads for both EM and DM credit datasets, albeit a stronger relationship for developed markets[1]. This suggests that deteriorating ESG factors can be indicator for deteriorating financial weakness and even feed directly into credit risk. If this is true, then incorporating ESG risk into EM sovereign portfolio construction should in theory help improve performance by reducing exposure to weaker and more volatile names. Although, some of these differentials might not really manifest themselves until the next major fixed income bear market.
We can demonstrate this ESG outperformance thesis through backtesting and flexing ESG weightings: we found that the Governance risk factor has a material impact on returns historically. Increasing the strength of each pillar in isolation, shown in figure 1, shows that increasing the weight of countries with higher Governance performance improves the historical return of the portfolio. This is not true of Environmental and Social performance based re-weighting.
The FTSE ESG EMUSDGBI (US dollar bonds issued by EM sovereigns) applies a three-pillar tilt approach to market value weights, using Beyond Ratings’ ESG scores[2]. However, the E and S factors have a smaller contribution to the resulting factor tilt compared to the Governance pillar. Countries with higher ESG scores are overweighted while countries with lower ESG scores are underweighted, with an emphasis on countries with high Governance scores.
The result is an increased average ESG score of 56.36, 14% higher than the market value weighted index. At the same time, return per unit of risk is higher and tracking error versus the base index is 1.9%.
The biggest drawdown suffered by each index was between January and March 2020, with the base index dropping by 14.5% compared to 10.9% for the ESG index. The under-weighting of those countries with the worst drawdowns, such as Ecuador or Angola, dampened the downwards impact of the covid crisis on the index. More generally, volatility is noticeably lower at 7.1% versus 7.9% for the base index over the 10 year period.
In this example, our ESG index demonstrated improved returns, less severe drawdowns and lower volatility. We think that these differences would be even more noticeable in a higher yield and higher volatility when credit differentiation becomes a greater determinant of performance.
The growing demand for ESG ETFs and funds demands a difficult combination of objectives. The new indices need to be sustainable, without substantial tracking error and without additional turnover. Often this can only be achieved by sacrificing performance or increasing volatility but in the case of EM ESG indices this can be achievable with improved returns.
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[1] Pricing ESG risk in sovereign credit, Federated Hermes and Beyond Ratings, Q1 2020
[2] Developed within the Sovereign Risk Monitor.
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