Attitude towards market change has been slow historically but the evolution of ESG portfolios has been an exception. The need for a new generation of ESG fixed income indices is already changing the fixed income landscape and will increase as investor priorities continue to evolve. This paper looks at how we intend to adapt our existing passive, market-weight indices to meet this rapidly changing dynamic. We work through the process of taking a dollar EM index and adapting it with an ESG tilt factor, and enhancing the backtested return with a carry factor.

We believe applying factors to traditional fixed income indices will be more valuable in the future than it has been in the past. Since 2009 quantitative easing (‘QE’) and easy-money has resulted in a bull-market, low default, high correlation fixed income world. In this world, traditionally based analyst research and fundamental asset selection has not been as successful as a leveraged, high-beta, lower quality approach. With rates rising and QE unwinding, these macro supports are gone and there is likely to be more portfolio performance differentiation in the years ahead.

Equally, with sustainable investments growing as an asset class, current SI-premiums are likely to be more pronounced in the future than they have been in the past. While ESG methodology may evolve, and priorities shift, it seems improbable that investor appetite returns to focus more on returns, at the exclusion of everything else. Therefore, the future might see more differentiation than can be discerned from looking backward.

In the first section, we provide an overview of the process of new index creation by outlining our objectives and method. In the second section, we examine the application of an ESG tilt factor in more detail and the resulting effect it has on the risk of the portfolio. In the third section, we add a ‘carry’ factor and repeat our risk analysis. Finally, we make some broad conclusions about what we have created with our new index method.