One size does not fit all, so investors need to work harder on ESG strategies

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Every investor wants environmental, social and governance (ESG) exposure, but only the largest have the resources to comprehensively assess this for themselves.

As the demand for standardized measurement grows, fixed income in particular has a lot of work to do to catch up.

In January, index provider MSCI launched a series of new fixed income ESG and factor indexes, a recognition that investor demand for ESG integration in fixed income is rapidly outpacing current offerings.

Hitendra Varsani,

“The indices were launched to meet client demand,” explains Hitendra Varsani, factor strategist at MSCI. “Clients want to target fixed income exposures that align with their own objectives and many global asset owners are demanding ESG integration.

“There has been strong growth in equities, but the choice in fixed income is relatively more limited.”

MSCI has operated an ESG Leaders Index in the equity markets for several years and is now applying it to fixed income. It is also launching an ESG Universal Index for fixed income. These products apply ESG ratings from triple-A to triple-C; they incorporate ESG controversies consistent with international norms and screen businesses for involvement in certain activities.

Fitch recently published a ranking of the top 11 corporate sectors by negative screening, which put metals and mining at number one and technology and media at number 11. The higher ranked corporates, with the exception of gaming, lodging and leisure, tended to be screened out on environmental issues while the lower ranked on governance issues.

“So far, only Standard and Poor’s and Fitch have disclosed statistics on the actual number of financial and non-financial issuers which had their credit rating impacted by ESG considerations, and these remain limited [28 for S&P and 345 for Fitch],” says Ines de Tremiolles, global head of Credit 360 at BNP Paribas, recently.

“The main obstacles declared by the credit rating agencies have been the lack of visibility on ESG factors and the materiality of ESG risks within the rating horizon.”

Materiality has become a key concept in the drive to embed ESG into the investment process.

“We are looking at the financial materiality of ESG factors in fixed income,” Varsani confirms when asked about the construction of the new indices. But how should materiality be measured?

The financial materiality of ESG factors involves establishing what sustainability issues are material to different companies and industries.

“It is generally acknowledged that material ESG issues by industry can change over time for a variety of reasons,” says Robert Eccles of Saïd Business School, Oxford University, and the founding chairman of the Sustainability Accounting Standards Board (SASB).

Given how central materiality is to ESG investing and fiduciary duty, it is critical to understand the mechanisms by which ESG factors impact the operational and financial performance of companies 

 – Andre Shepley, Truvalue Labs

He adds that there are three core materiality issues – greenhouse gas emissions, labour practices and business ethics – that have been especially important for the past 10 years because of their system-level effects.

It is, therefore, crucial that an agreed measure of materiality can be determined.

At the end of January, San Francisco-based Truvalue Labs published a paper introducing the concept of dynamic materiality: that every company, industry and sector has a unique materiality signature that evolves over time based on factors such as emerging technologies and new regulations.

The firm, which specializes in artificial intelligence-driven ESG data, says that this indicates that ESG materiality is driven by stakeholders’ perspectives regarding individual companies, in addition to factors related to the industry and sector as a whole.

“Given how central materiality is to ESG investing and fiduciary duty, it is critical to understand the mechanisms by which ESG factors impact the operational and financial performance of companies,” says Andre Shepley, head of fundamental research at Truvalue Labs.


It is vitally important that asset managers get this right, as the pressure to incorporate ESG measurement into performance is now intense.

“A standard in the market hasn’t emerged yet – we are walking that path at the moment,” says Varsani. “Ratings are becoming more transparent and methodologies more comprehensive, and investors are becoming less tolerant of corporate ESG incidents.”

This is true across all fixed income asset classes, from sovereign debt to short-term money market funds. And asset managers are starting to move quickly to show that they recognise this.

Lyxor Asset Management recently announced the integration of ESG filters into its sovereign bond management business, integrating a country’s overall ESG score to assess its long-term economic sustainability in view of its exposure to ESG risks.

Using MSCI ESG data, the firm has given governance a weighting of 50%, whereas the other two factors each have a weighting of 25%.

“The integration of non-financial criteria into our liquidity buffers management enhances and complements traditional financial analysis of government default risks and consequently provides a comprehensive view of risk that is compatible with sustainable investment principles,” says Florent Deixonne, head of sustainable and responsible investments at the firm.

In a January report looking at ESG trends for 2020 published by MSCI, analysts emphasized the increase in global asset managers offering ESG money market funds – whose number grew by 15% in first half of 2019.

In November, Goldman Sachs Asset Management added ESG criteria to the Goldman Sachs Euro Liquid Reserves Fund, screening out controversial weapons, tobacco, civilian firearms, alcohol, adult entertainment, gambling and certain fossil fuels.

“Each ESG money-market fund may aim to integrate different ESG criteria, from engagement with issuers on diversity to donating a portion of proceeds to carbon offsets,” the MSCI analysts say.

“Companies relying on commercial paper for short-term borrowing could find themselves ineligible for fund inclusion, even if they operate relatively non-controversial businesses.”

It is second-order impacts such as this that demonstrate the need for the fixed income market to work harder on standardization. Its heterogenous nature makes this an urgent priority.

“The need for customization is a key driver: it is arguably more critical in fixed income than in equities and might therefore need a level of engagement with clients that is exponentially higher,” Varsani points out.