Sage Advisors, a well-known money manager with some 20 years’ experience in fixed-income investing, has created an ESG-focused (environmental, social, governance) bond index, the Sage ESG Intermediate Credit Index, with Wilshire Associates.

According to the firm, the index, which picks some 110 investment-grade securities from the Barclays Intermediate Credit Bond Index through ESG factors, is designed to mitigate risk and generate better returns over time than a vanilla allocation.

Bob Smith, Sage’s president and chief investment officer, and Ryan O’Malley, portfolio strategist, tell us why ESG in fixed income is important, and how investors can access this strategy.

ETF.com: Let’s talk about ESG and fixed income. Why are you focusing on this theme, and creating an index?

Bob Smith: We have a history of running socially responsible portfolios for a dozen years in fixed income, particularly on the taxable side. The continued interest, and also the growing availability of data that is much deeper and broader in getting into the metrics behind the various components of E [environmental], S [social] and G [governance], was something that attracted us to it. Simply saying no to everything was easy, but how to say yes, and to do it in a way that was beneficial on two levels—the value set, and fundamentally from a financial return perspective—wasn’t easy. Better data helps.

The second motivation was that when you sit and look at the world of funds and ETFs out there, in terms of what socially conscious funds look like, there's startling differences between stocks and bonds.

On the equity side, based on Morningstar's universe, there are roughly 5,130 funds and ETFs out there that have about $11.5 trillion in assets, and only 216 are socially conscious, for about $193 billion. That ends up being about 1.7% of U.S. assets in Morningstar's universe—small, but growing.

On the fixed-income side, there are about 1,660 funds and ETFs with roughly $3.6 trillion. Only 42 are socially conscious, about $17 billion worth. That's less than 0.5% of all assets. There's a need, and there's definitely a gap.

ETF.com: From an investor perspective, what does an ESG focus means in terms of returns in a fixed-income portfolio?

Ryan O’Malley: One of the things you hear about in the equity world is that people engage with the management teams because you’re a shareholder. I’d argue that if you're holding bonds of a company, you have equal—if not greater—opportunity to engage with management.

Secondly, it impacts performance in fixed income. The strategy really tries to pick the best people who are leaders in their peer group, whether that's a communications company or a tech company or a bank or whatever. What you end up getting is a risk mitigation tool.

We've seen empirically from returns that you get about 50 to 60 basis points of positive incremental returns in a conservative fixed-income strategy. That may not be super-exciting to an equity person, but in the fixed-income world, that's pretty exciting.

You also have lower volatility. And you have an upward migration in Moody's and S&P credit ratings over time for the folks who do things the right way. People are always trying to figure out who's going to get upgraded and who's going to get downgraded—so, lower volatility, better credit ratings, better performance.

ETF.com: Why has the application of ESG to fixed income been so much slower than in equity? Is it that access to data has been a barrier? Because that would have also impacted ESG development in the equity side.

O’Malley: You use a lot of the same data set, that’s right. Equities have led the way, because sometimes in the fixed-income market, people are a little bit slower to pick up on some of these trends. In equities, you're worried about the growth of the future; in fixed income, you're looking at the current moment, and you say, “Can they pay me back?” That leads to a little bit of conservatism in fixed income. That's starting to change.

The other reason is—and this is also starting to change—that looking at the composition of equity indices versus the major fixed-income indices, the equity indices have a lot more tech companies and high-growth healthcare companies. People, by nature, like that. Fixed income traditionally has been the realm of old-school utilities and things like that. That's changing now.

The other thing is, when you talk about SRI [socially responsible investing] versus ESG, the tool kit for ESG in the last two to three years has really reached a critical mass where you can use this more and more. And that's part of the reason we've become more interested. I don't think two or three years ago we would’ve had the tools we do today.

The second thing is, when you talk about SRI versus ESG, in SRI, you're excluding entire industries. In the fixed-income universe—going back to my earlier point about the composition of the fixed-income universe—you can't just take out all of energy or all of utilities and say, OK, that's what we're going to roll with, because then you just introduced more risk from tracking error. You're missing out on large opportunities within the fixed-income universe that in the equity world I think is a little easier to ignore.

Now you can do a little bit of everything and make it so that it's more diverse across sectors. That wasn't really available 10 years ago, or even five, really.

ETF.com: Assuming you’ll use this index for an ETF, how different would the portfolio look compared to a vanilla aggregate type of bond strategy?

O’Malley: The beauty of such an ETF is that you wouldn’t have to be forced to take extreme fixed-income risk. That's something we're making a priority, when you look at the index on a risk factor basis versus the Barclays credit intermediate index, in yield, key rate duration, overall duration—it's almost identical. There’s a little bit of tracking error, but it's about 50 basis points a year. And it’s a highly liquid index.

From an ESG score perspective, what we're trying to reach for with this index is to have a score that's not wildly out of the park, because it's hard to do. If we can get to a standard deviation-and-a-half better than the average ESG value score within the underlying index, and provide you all this excess liquidity and then all of the characters being virtually identical to the underlying credit index, conventional index, then we think we've added some value to the whole process.

ETF.com: Is there investor demand for ESG in fixed income?

Smith: If you just look at the list of names that are on Morningstar, when you get into the world of ESG in fixed income, there are very few plain-vanilla, all-100% corporate- or credit-oriented kind of decisions. What happens?

Some of them have agencies, or have international/supranational. Some of them have Treasuries, some don't. Some have themes—we're going to be green and we're green-bond oriented; we're going to be socially conscious or religiously thematically oriented.

There's no pure play. There are very few pure plays, particularly for what we think is the absolute belly of the distribution in asset allocation, which is just plain-old intermediate fixed income.

You don't need ESG analysis to figure out which Treasuries are a greater value from that perspective, or for that matter, even agencies. You can say, well, housing agency securities probably are what I want to add in there. Their analytical importance of where you're going to get the greatest value is in the corporate arena, because government and semi-government, supers, and so forth, that's not where you need help. Where you need help is what we're doing.

This is a basic part of asset allocation. The corporate market is the area that people have been overemphasizing in their portfolios since QE has been underway. People have been Treasurylike, agencylike, corporate-heavy, and they need help in this regard.

ETF.com: To clarify, none of this is to be confused with green bonds, right?

O’Malley: Absolutely. Green bonds are fine; they have their place. But a green bond has to go through a green-bond kind of regulatory framework that basically says the company went through a checklist when they issued the bond and they got a rubber stamp from someone.

What I would say about the green bond index is it doesn't always end up really leading to real change or real, actual good policies. It leaves out the governance factor in ESG, which is one of the major things that mitigates risk.

If you look at the composition of the green bonds index, and the composition of the VanEck Vectors Green Bond ETF (GRNB), there's not a lot of sector diversity. It's almost all banks. And there are a lot of sovereign bonds in there. So you're getting a concentrated portfolio of a few different issuers. This is not diversification; this is concentration when you go that route.

ETF.com: Is ESG a quality screen at the end of the day, or are there downsides to focusing on ESG?

Smith: It’s a bit of a quality screen, because there's a lot of evidence that it correlates to credit-rating migration over time. The risk we try to avoid is lack of diversification. We try to make sure each sector was represented within the portfolio so that you didn't have large sector over or underweights.

Contact Cinthia Murphy at cmurphy@etf.com. To get the latest ETF news in your inbox, sign up for the ETF.com Daily Newsletter.

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