ESG's tipping point
TwentyFour Asset Management’s purpose-built Observatory platform scans the global universe of bonds looking for ESG stars.
The Observatory is a proprietary bond database and relative value tool built by TwentyFour Asset Management, which helps the firm measure and track the ESG credentials of different bonds and issuers from across the global fixed income universe.
Observatory is like TwentyFour’s very own search engine for the bond markets, storing key metrics on over 26,000 securities across sovereigns, credit and high yield. ESG analysis is built right into this software alongside more familiar metrics to bond investors such as yield and maturity, which ensures ESG is a factor in every investment decision TwentyFour’s portfolio managers make.
Observatory is populated with external data from Asset4, a Research Financial ESG database, along with the group’s own in-house ESG research. It allows the portfolio managers to score all the bonds they invest in on a range of quantitative and qualitative ESG metrics and update these scores on a regular basis.
Observatory is at the core of TwentyFour’s ESG integration, but it is also the tool that powers the firm’s sustainability focused funds, as it allows portfolios to be screened positively and negatively by ESG score.
When it comes to fixed income, passive index strategies face a number of limitations. Chief among these is the data challenge. Due to the nature of the fixed income universe, where a large number of issuers are not publicly listed companies, data coverage is average at best, with up to 40% of the investment universe typically not covered. Naturally, this creates a problem for building an ESG fixed income index.
But even where data is available, there is no guarantee that a company with a high ESG score is truly making the world a better place. Graeme Anderson, a founding partner at TwentyFour Asset Management, says “rule-based systems can be gamed” by large corporations that have money to throw at ESG reporting, resulting in ESG data being skewed in their favour.
He gives Coca-Cola as an example, a company most of us would not consider an ESG investment. The company contributes to plastic pollution and child obesity by selling sugary drinks to children.
However, Anderson points out that in most databases, the company scores well as it knows how to profile itself. “So if you just take a rating or a profile with a passive fund, you're probably buying Coca-Cola,” he says.
The other concern is that a passive ESG strategy ignores a company’s direction of travel, which TwentyFour has dubbed the “momentum score”, as the resources for this research simply aren’t there. This means that even if the companies in a passive ESG fund are as good as their ESG score suggests, there is a missed opportunity in terms of driving positive change. For many investors, this is the real goal of ESG investing.
“Some of the best-performing credits are likely to be those companies that score relatively poorly today but are committed to change,” says Chris Bowie, partner and portfolio manager at TwentyFour. The best way for fixed income investors to drive this change, he believes, is regular engagement with companies: something a passive fund, yet again, is unable to do.
But part of the problem also comes down to the nature of bond investing itself, according to Bowie. When investing in equity, the upside is “essentially unlimited”, he says, while as a credit investor, “the best thing that can happen to you is that you get your money back”. As such, bond investors “have to be very careful about who [they] loan money to because there is more downside risk than upside”.
Anderson adds that a fixed income investor is often required to quickly engage with companies in response to market events, such as a subversive buyback of a bond, which necessitates an active management team.
Finally, and perhaps most importantly for investors, TwentyFour’s research shows that applying negative exclusionary screens – the most common approach to passive ESG investing – can be detrimental to returns in credit investing, while simultaneously increasing volatility.
This was the conclusion of quantitative testing on the firm’s Absolute Return Credit fund when TwentyFour was preparing to launch its sustainable product suite. The firm's ESG bond strategies feature a carefully calibrated mix of negative and positive screening, which requires detailed research and data. This comes back to the issue of data availability, a key stumbling block for passive investing in fixed income.
Equally, many of the passive ESG fixed income funds in the market invest in green or sustainable bonds, which according to Anderson is often the least preferable choice for those wanting a truly sustainable fixed income portfolio. While typically offering a low level of yield, he notes the green bond market also currently applies a rules-based ‘box-ticking’ approach which “simply doesn’t cut it in the world of ESG”.
Clearly, the reasons for choosing an active approach to ESG fixed income are numerous. Active managers can help solve the data scarcity problem, drive positive change through engagement, quickly respond to controversies and support companies on a path to improving their ESG credentials. Coupled with the promise of a similar risk-adjusted return to their traditional fixed income counterparts, active ESG bond funds can be the product of choice for investors who are serious about putting their money to good use.
The Data Problem: ESG data in the fixed income space is often limited and typically covers only up to 60% of the investable universe, so index construction can be difficult and unreliable. Active managers are able to fill this data gap through rigorous in-house research.
Inconsistent Scoring: Different ESG data providers often award the same company vastly different ESG scores based on the issues they consider material. For example, Tesla typically gets a high environmental score for its work on electric vehicles but is given a low governance score and marked down for toxic material mining practices. So is it a good or bad ESG investment? That will depend heavily on the data provider, and what weighting their scoring process gives to the E versus the G.
Qualitative Metrics: Active research takes into account qualitative metrics such as controversies, which rules-based models often struggle to pick up. Even when they do, what some of these models consider material may not be a negative issue. For example, the Asset4 model considers acquisitions a ‘controversy’, something the TwentyFour portfolio management team disagrees with, since acquisitions are not inherently positive or negative and bondholders can judge each on its own merits.
Forced Buyers: Passive funds can become forced buyers when an index is rebalanced, and conversely cannot sell out of a company that is in the index. As a result, engagement that will actually drive change is difficult or impossible.
Static Approach: Passive investing doesn’t take into account momentum, i.e. a company’s movement in the direction of positive or negative change. Negative screening rules can work in some circumstances, but the role of sustainable investing is also to push for better ESG outcomes, for which an active approach is far better suited.