Sustainable ETF Investments in the Post-Pandemic World

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Although COVID-19 has changed the face of the global economy and added new levels of volatility to financial markets, we have repeatedly heard from sustainable investors that their strategies have been able to successfully weather the crisis, often even outperforming traditional benchmarks. One market segment where this disparity is evident is in exchange traded funds (ETFs).

- Promotion -

In the twelve months to July 2020, the value of sustainable ETFs doubled to US$52 billion thanks to the appeal of ESG strategies during the COVID-19 drawdown. This performance is consistent with the empirical observation that companies with a higher Environmental, Social and Governance (ESG) rating tend to be more resilient and experience lower drawdown during instances of market turbulence. Indeed, data from UBS Asset Management shows that the COVID-19 experience was no exception to this longer-term trend. While investors withdrew from broad equity and fixed income ETFs, ESG ETFs experienced inflows worth US$17 billion in the nine months through to September (Figure 1).

According to the Swiss asset manager, in the first seven month of 2020, ESG ETFs represented 23% of all net new investment inflows into European ETFs, so that by the end of July European ESG ETFs represented 5% of the share of the whole European ETF market. The rise in the share of new net money flowing into ESG “signals strong growth”, according to research by Puri Tarun, Matthias Dettwiler, Christian Kunth, and Marcin Wojtowicz at UBS AM[1].

“Breaking down the growth between Equity and Fixed Income ESG solutions, you can observe in figure 2 how, without surprise, this growth is mostly driven by Equity ESG Market which appear to be more mature,” the UBS team explains. “In fact, ESG ETFs captured 47% of the inflows into equity ETFs between January 2019 and June 2020, while fixed income ETFs’ share was only around 6% during the same period. The adoption of ESG in fixed income is therefore likely to catch up in the near term. With the recent launches, there are now available 32 European-listed fixed income ESG ETFs covering main bond sectors such as corporates, sovereigns and emerging markets (30 June 2020, ETFGI).”

Renewed Investor and Policy Support

According to UBS, the Coronavirus epidemic is likely to trigger a paradigm shift in a range of economic practices and sectors, which are supportive of ESG investments, be it healthcare, education, transportation and renewable energy. “Investors are using their influence to drive behavioural changes, in a sign that shareholder engagement should remain a key component of sustainable investment going forward,” Rachel Whittaker, Andrew Lee, Michaela Seimen Howat and Antonia Sariyska, from UBS say [2]. Not only have many of the companies in those natural ESG sectors been able to provide solutions to the limitations imposed by the pandemic, they are also likely to benefit from the solutions and rescue packages organised by governments around the world.

Many national governments have answers the April 2020 call of the UN Secretary General António Guterres to focus economic rescue packages on businesses that “steer our world on a more sustainable and inclusive path – a path that tackles climate change, protects the environment, reverses biodiversity loss and ensures the long-term health and security of humankind. By making the transition to low-carbon, climate-resilient growth, we can create a world that is clean, green, safe, just and more prosperous for all.”[3]

In the EU, companies rescued by public aid will be barred from paying executive bonuses and aggressive commercial expansion until the aid has been repaid. Moreover, not only have member states endorsed the Green New Deal, they have endorsed a fiscal stimulus package to manage the pandemic. But governance issues have also been highlighted. In Denmark, government bailout programs exclude companies located in tax havens, for example.

Sustainable Fixed Income After COVID19

Fixed income markets offer an appealing channel through which investors can gain exposure to the companies riding the new growth opportunities created by COVID-19. At US$40.9 trillion, corporate bonds represent almost a third of the US$128.4 trillion global bond universe4. Asides from the large liquidity of this market, there are several other reasons for the appeal of fixed income as one of the main channels through which investors could gain exposure to new sustainable trends. “Many investors prefer credit over equities, given bond-holders’ preferential claim on corporate cash flows in a highly uncertain economic environment. With a vast array of maturities, yields and credit quality available, investing in corporate bonds has the potential to provide higher yields than government bonds as well as providing diversification benefits for investors,” Tarun, Dettwiler, Kunth and Wojtowicz explain.

In parallel, the rising popularity of ESG in fixed income seems to also have been reinforced by investors’ reaction to the COVID-19 pandemic. Indeed, the strides made during the crisis to use social bonds as a channel for funding coronavirus initiatives signals a growth for this entire segment going forward.

Green bonds and Social bonds are the dominant direct investment opportunities in sustainable fixed income. Since 2014, the total green bond market has risen to over €750 billion and has become a core component of any sustainable investment portfolio. “Demand remains high and green bonds are likely to play a key role in the European Commission’s action plan to finance sustainable growth,” Whittaker, Lee, Howat and Sariyska say. According to the UBS analysts, the EU green bond standards provides “strong drivers in European green bond markets, but also having a global effect on the quality of green bonds, and influencing advancements with regard to other investment products along the lines of transition, social, and SDG-linked bonds.”

Social bonds have traditionally been obscured by the popularity of their green counterpart and the prominence of the climate change concerns they address. However, the rise of COVID-19 fuelled an explosion of social projects and investments which social bonds were tasked with funding. “In April 2020, in the midst of the COVID-19 crisis, issuance of bonds with ESG characteristics increased by 272% y/y, including for the first time, sustainability bond issuance (US$19.4 billion) exceeding green bond issuance (US$16.8 billion) in a single calendar month (according to Morgan Stanley),” Whittaker, Lee, Howat and Sariyska add.

Fixed Income ESG ETFs

Florian Cisana,
Head of Passive and ETF Sales Nordics, UBS ETF

For investors unwilling or unable to tap these investment opportunities directly, fixed income ETFs can offer an appealing alternative.

“We have seen strong investor interest with year-to-date inflows of USD 5bn into our ESG ETF range as per end of August. Our offering currently consists of seven fixed income ETFs with ESG screening which provide clients with the opportunity to gain exposure to global sustainable corporates, development bank bonds as well as sustainable Government and emerging market bonds. We are keen to keep developing innovative ESG solutions to best serve our client´s needs. Just this month we have launched the first ever ESG ETF with exposure to European treasuries”, says Florian Cisana, Head of Passive and ETF Sales Nordics.

Sustainable fixed income indices are developed in cooperation with multiple index providers, using data from several ESG rating providers. For example, the largest portion of the UBS ETFs within the fixed income ESG category tracks “Liquid Corporates Sustainable Indices”, with exposures to the US Liquid Corporates Sustainable, Euro Area Liquid Corporates Sustainable and Global Liquid Corporates Sustainable indices. The indices are built around a multi-step process starting from an existing corporate benchmark, say the Bloomberg Barclays Global Aggregate Corporates index. The index then undergoes a liquidity filtering as well as ESG screening. Firstly, bond issues based on a variety of liquidity criteria (e.g. time since issuance, amount outstanding) are selected in order to target the most liquid part of the universe. As a consequence, several older short maturity bonds are removed, increasing the duration of the MSCI Global Liquid Corporates Sustainable Index to 8.69. On the resulting portfolio, UBS then applies a three-step ESG screening process. Firstly, bonds with a MSCI ESG Rating below BBB as well as those securities that are unrated from an ESG perspective are excluded. Subsequently, businesses involved in a range of problematic industries (i.e.: Alcohol, Tobacco, Gambling, Adult Entertainment, Genetically Modified Organisms (GMOs), Nuclear Power, Civilian Firearms, Military Weapons) are also excluded. The final exclusion consists of companies which are red-flagged by the MSCI ESG Controversies Score as well as those that do not adhere to international norms.

Typically, ESG versions of standard indices exhibit limited tracking errors versus their parent benchmarks and are considered as a suitable replacement for the core allocation to these exposures. The performance figures suggest that sustainability does not hinder financial objectives, but has a complementary effect. For the selected benchmarks, UBS finds that the sustainable portfolios perform at least as well as the standard benchmarks within fixed income.

For example, the Bloomberg Barclays MSCI Global Liquid Corporates Sustainable Index has delivered a return of 6.04% per annum in the period from 31 July 2015 to 31 July 2020 which equals an annual outperformance of 0.77% versus the standard index.
According to the Swiss bank, these insights support the hypothesis that an ESG focus can be seen as a competitive advantage, which may allow companies to deliver better long-term value to investors.

[1] “UBS ETF On Track Research – Sustainable Fixed Income”, September 2020, by Puri Tarun, Portfolio Manager Index FI EM; Matthias Dettwiler, Head Index Fixed Income, Managing Director, UBS AM; Christian Kunth, Product Development Passive, Executive Director, UBS AM; Marcin Wojtowicz PhD, ETF Research & Analytics, UBS AM
[2] “Sustainable investing after COVID-19”, 12 May 2020, Chief Investment Office GWM Investment Research, by Rachel Whittaker, CFA, Analyst, UBS Switzerland AG; Andrew Lee, Head Sustainable & Impact Investing, UBS Financial Services Inc. (UBS FS); Michaela Seimen Howat, Analyst; Antonia Sariyska, Analyst, UBS Switzerland AG
[3] “Remarks to Petersberg Climate Dialogue”, 28 April 2020, António Guterres
[4] August figures from the International Capital Markets Association (ICMA)

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