When renowned British composer Andrew Lloyd Webber struggled to find a suitable actress to play the role of Maria Von Trapp in The Sound of Music, he resorted to a television talent show as a last-ditch attempt, writes Sparrow Capital’s Mark Northway (pictured).
Passive sustainable fund managers are involved in an equally frustrating search to find a way of gaining exposure to bonds in the same way they access other asset classes.
According to Morningstar, passive funds in the US gathered $958bn in 2021 out of a total $1.2trn invested, so it’s entirely logical that index investors are seeking ways to boost passive exposure to fixed income while adhering to ESG investment criteria.
But is the fund industry at the point where it can genuinely offer investors such a solution?
A dubious offering
It’s a source of frustration to us that there is currently very little to choose from in the way of safe, sustainable indexed fixed income offerings.
Index investing works well in equities because those securities are exchange traded and generally offer sufficient liquidity to enable frequent transactions.
With bonds, secondary trading is much more limited. Many older issues are of limited size and are locked away in pension funds. The corporate bond market trades over-the-counter (OTC), effectively by appointment, and the penalties for being caught with a technical short position can be draconian.
Away from government securities, liquidity is limited and can quickly disappear. It is very difficult for market makers to provide consistency across the full spectrum of bonds.
Adding an ESG filter to fixed income amplifies these issues hugely. Many sovereign borrowers fall foul of ESG rating processes, and resulting indices tend to contain an unacceptable percentage of esoteric corporate bonds.
Liquidity risk is iniquitous, and an investor won’t usually be aware of it until it bites. Indices which assume secondary market liquidity are a disaster waiting to happen.
In our own view, existing products in this space are not yet fit for purpose; our compromise is to stick to developed government bond indices within our ESG fixed income strategies at this point.
For the avoidance of doubt, our focus here is on ESG/SRI instruments only. During the 2018, 2020 and 2022 market stresses, broad market bond ETFs showed resilience as, in the secondary market, liquidity and volumes were still buoyant and pricing there was used by market participants in the OTC markets as a price gauge.
The issue is that ESG and SRI weightings and filters can result in an esoteric index which ignores those sectors within fixed income markets, notably sovereign debt. which benefit from deep natural liquidity.
Room for innovation
Some alternative strategies were put forward in a recent ETFGI panel discussion on the topic of how investors are implementing ESG in their portfolios.
One panellist confirmed that their firm used active fixed income managers to gain exposure to ESG bonds, while another used a passive approach, in spite of acknowledging the aforementioned liquidity risk and the potentially large transaction costs.
But there may be room for an innovative product to fill what we perceive to be a major gap.
Firms such as Kamakura Corporation, a risk management consultant, assess the relative value of fixed income holdings from both a credit risk perspective and a liquidity perspective, providing an overlay mechanism which could guide an intelligent indexing approach in ESG space.
By harnessing a process that pinpoints the liquidity of a bond, it may be possible to create an ESG bond index that selects its constituents with an eye to how easy it is to buy and sell the underlying holdings in times of stress.
There have been some initial steps in this direction, and a recent working paper from NBER sets out interesting empirical evidence of manager behaviour, but it makes eminent sense for the ETF and index fund industry to explore more formalised approaches to liquidity management in ESG/SRI space.
Liquidity is too frequently overlooked by investors, and it has been the downfall of entire fund sectors – structured investment vehicles and open-ended property funds – and so-called star managers, such as Neil Woodford.
Anyone buying an ETF in this specialist area of the fixed income market needs to stop and think very hard indeed. Rather than waiting for their Maria, it might be best for passive investors looking for ESG bond exposure not to let the perfect be the enemy of the good.
This article was written for Portfolio Adviser by Mark Northway, investment manager at Sparrows Capital.