ESG: Products need to walk the walk on sustainability metrics

News and opinion on finance

In late August, news emerged that a $578 million socially responsible exchange-traded fund (ETF) managed by Vanguard Group contained shares in a range of non-socially responsible firms – including a gun manufacturer and a private prison operator. 

The shares were added in error, the result of a mistake in the underlying index provided by FTSE Russell, which has subsequently committed to strengthening its processes.

This episode highlights just how important thorough due diligence is for investors that are looking to increase their exposure to environmental, social and corporate governance (ESG) assets even through passive tracker funds. For ETFs there are a range of options when it comes to deciding what the underlying will be. 

“Deciding on ESG criteria is always a complex discussion,” says Oliver Kilian, a director within UniCredit’s ETF Advisory & Trading unit.

Oliver Kilian,

UniCredit recently announced the listing of two ETFs based on the eurozone’s first set of indices combining a factor strategy with ESG screens. The ETFs will track the Euro iStoxx ESG-X & ex nuclear power multi factor index and Euro Stoxx ESG-X & ex nuclear power minimum variance unconstrained index. 

Both indices are based on the Euro Stoxx index and apply standardized ESG exclusion screens. 

“What’s clear is that the stronger the ESG filter, the more concentrated the investment universe you have to work with,” Kilian tells Euromoney. These are the first products to look at smart beta strategies on European equities with an ESG overlay.

For asset managers that want to look outside passive funds for ESG exposure – be it in equities or fixed income – there is a decision to be made on the extent to which criteria should be reliant standard ratings, such as those produced by MSCI or Sustainalytics.

“If you have no ESG data and start with MSCI, the question is: are the types of key issues they are scoring sensible?” says Bhupinder Bahra, co-head of the quantitative research group, global fixed income, currency and commodities at JPMorgan Asset Management. 

“You have to look at whether the scores coming out have information content and whether they can be used to outperform benchmarks. Would you wholly rely on them? No, you wouldn’t.”

JPMorgan recently published a research report that back-tests the impact of an ESG overlay on corporate bond portfolio construction. “This study was done to inform investors as to what would happen in their portfolios as they start tilting towards ESG,” Bahra says. The team back-tested investment-grade, high-yield and emerging-market bonds.

Rating agencies have traditionally been focused on more immediate operating and financial metrics … but if you are a specialist ESG investor you will possibly want to give a bigger weighting to potential governance issues 

 – Bhupinder Bahra, JPMorgan Asset Management

The assumption that ESG criteria will move together is often not the case. “Correlations amongst the E, S and G pillars have decreased through time,” Bahra explains. 

“This may be because of increased data coverage by MSCI post-2012, and perhaps also due to an increased specialization of analysts within each pillar. Consequently, the information content, and the quality of insight of MSCI’s component E, S and G scores, has improved over time.”

The research also illustrates how important it is to look at both credit ratings and ESG ratings as they can be very different. “The time series of the correlation of governance scores to agency credit ratings currently shows a slightly negative correlation,” Bahra says. 

“Rating agencies have traditionally been focused on more immediate operating and financial metrics rather than, say, longer-term governance concerns per se, to come up with a current rating. But if you are a specialist ESG investor you will possibly want to give a bigger weighting to potential governance issues.”

Bhupinder Bahra, JPMorgan Asset Management

He adds: “It is all about time horizons. For example, ESG analysts are potentially scoring more heavily on longer-term governance factors than a rating agency analyst would do on a quarter or year ahead view. Long-term investors would focus more on the long-term time horizon. 

“It is not necessarily beneficial to merge traditional credit ratings and ESG ratings, as both views – shorter term and longer term – are relevant and should arguably be assessed separately.”

For many specialist impact investors, taking direct control of the ESG eligibility decision process is the only answer.

“Sustainalytics and MSCI are doing a good job, but they are not fully there – there are gaps,” says Vishal Khanduja, fixed income portfolio manager at Kansas City-based specialist ESG investor Calvert Research and Management, a subsidiary of Eaton Vance. 

“This is the way that a market matures. Investors should not rely solely on agencies for ESG ratings or for credit ratings,” he warns. “We have tried to fill the gap. In any discipline, be it ESG or otherwise, it is an investment decision. We have a dozen ESG analysts solely looking at ESG who dig through every aspect of a company’s available information to identify what is financially material. 

“We are also doing impact research in the area of green bonds’ use of proceeds. We have looked at 200 industries and using SASB [Sustainability Accounting Standards Board] criteria, we have created ESG models for each one as a guide in our process.”

This is a resource-intensive approach, but one that Khanduja believes is worth it. 

“The point of having an in-house team is that we can conduct our own research in order to evaluate what issuers invest in even if they don’t have an ESG score – even if they are private,” he says. 

“For example, we can invest in ABS [asset-backed security] of private companies that meet our ESG criteria. The goal is to have maximum performance and maximum impact.”


There are many pitfalls for the unwary in an immature space that is attracting so much investor attention. “We are watchful and mindful,” Khanduja tells Euromoney. 

“There is a lot of euphoria in the market and it is still maturing. Economic incentives can be misaligned between issuers and those bringing these issues to market. We need to know that we can measure improvement in a scalable fashion and that there is enough data to do so effectively.”

Vishal Khanduja,
Calvert Research
and Management

As a longstanding investor in the space, Calvert is cautious about some of the newer products that are now being developed. The firm has focused on green bonds in order to have higher impact and to remain very close to where the proceeds will be going. 

It is, however, cautious on less proceeds-specific products, such as sustainability improvement loans. 

“We have not yet invested in sustainability improvement loans because we need more information on how the incentives will be distributed,” says Khanduja. “We want to encourage the development of the market but not at the expense of having a full grasp on how improvements will be measured.”

Leonie Schreve, global head of sustainable finance at ING, argues, however, that such products are an important step forward in improving corporate sustainability performance. 

The bank was the first to introduce sustainability improvement loans and recently introduced the world’s first sustainability improvement derivative (SID), a derivative with a credit spread that is linked to sustainability performance.

“Sustainability improvement loans are a strong and simple idea and sustainability improvement derivatives are based on the same concept,” Schreve argues. “You always have a combination of the finance function and the sustainability objective and the targets are ambitious. So far, half of the sustainability improvement loans we have done have met their targets.” 

The sustainability improvement derivative hedges the interest rate risk of financing the construction of one of Dutch oil and gas group SBM Offshore’s floating production storage and offloading facilities. It is the world’s first derivative with a price partially based on the company’s sustainability performance. 

A spread is added that can increase or decrease depending on the company’s ESG performance, as measured annually by Sustainalytics.

The hedge is being provided to SBM Offshore in connection with its existing US$1 billion, five-year sustainability improvement revolving credit facility. 

“We had already done a sustainability improvement loan with SBM Offshore, so it was relatively easy for them to introduce the derivative,” says Schreve. 

“You really want to have joint objectives on having sustainable goals. The change in rate will not be more than 10bp up or down. We consider that this is what works. You aren’t selling it for the discount, you want to have a serious commitment and join forces in accelerating their ambition.”

As more and more investors allocate to ESG, the range of products and their impact measurability will inevitably grow. The market is maturing and there will be some bumps along the way. But the attention that is now being paid to ESG investing is such that all products must be above and beyond question when it comes to adhering to whatever set of criteria have been decided upon.

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