Loopholes allow bad actors into fixed income ESG ETFs

AFII’s director of research identifies weak points in index construction and how they can be addressed

Jamie Gordon

a factory with smoke coming out of it

There are several structural issues allowing ‘bad actors’ like the Adani Group into ESG indices and in fixed income ETFs, the challenges are even more complex, Stephanie Mielnik, director of research at Anthropocene Fixed Income Institute (AFII), told ETF Stream.

Mielnik, who spent more than a decade in quantitative analysis and product structuring at Natixis and Northern Trust Asset Management, warned the broad-brush stroke approach of passive indices can leave products exposed to non-stringent ESG criteria, patchy or inconsistent data and a lack of asset-specific expertise.

Index design

Beginning with the adage that ‘your ETF is only as good as its index’, Mielnik said bad actors can appear in ESG indices because of design flaws such as not capturing all sustainability criteria.

“For example, an ESG index may have strong exclusionary criteria on tobacco, weapons and palm oil but no rules around thermal coal – and this can create issues such as the inclusion of Adani Group in ESG indices,” she said.

Defining these rules also means defining thresholds for excluding companies in certain industries. These could include a company’s revenue exposure to thermal coal mining, however, where a revenue threshold is set determines whether companies with material exposure to controversial industries remain in an ESG index.

“Sometimes there is a high proportion of companies with a small portion of their revenues linked to controversial businesses,” Mielnik continued. “If you exclude all of these and your tracking error and concentration risk increases, some institutional investors might not be willing to invest in indexed products such as ETFs that deviate too far from their parent index.

“This constraint might lead index providers and asset managers to set exclusion thresholds more or less high.”

Data structures

Next, data structures – or how activities are being classified – need to be considered. Mielnik warned the same company may appear to have different revenue involvement in the same industry depending on whether an index provider uses the BIC or GIC or other industry classifications, resulting in them being included in some ESG indices and excluded from others.

She added there is a broad range of metrics that are left to index providers to define in ESG. For instance, emissions can be viewed in absolute terms, based on different ‘Scopes’, future anticipated or intensity.

“ESG metrics such as carbon intensity which can be defined differently depending on the data provider, based on revenue – inflation adjusted or not – enterprise value, average revenue over time and so on.

“These differences create opportunities for bad actors to be included in some indices and not others because of different metrics’ calculations.”

Data quality

Even if index providers are as watertight as possible on index design and data structures, they can fall down on data quality, especially when companies do not report on every ESG metric.

This means data providers resort to filling data gaps with “varying statistical techniques” of varying accuracy. This can result in bad actors – which are awarded sector average scores – gaining unearned allocations despite a lack of reporting as index providers look to provide broad market coverage for diversified indices.

“This is particularly true for small cap or high yield indices, where reporting might not be so great,” Mielnik continued. “The percentage of reported versus calculated data is not very well communicated and it is something investors should be mindful of.

“Also, there are companies that provide inaccurate data. Corporates might not follow global carbon accounting standards or report emissions on only part of their businesses.”

Fixed income specifics

In bonds specifically, Mielnik said the asset class has specificities that are misunderstood and instruments’ structures are not always properly integrated into index construction.

One example uncovered by AFII last year was the L&G ESG Emerging Markets Corporate Bond UCITS ETF (EMAU), which is meant to exclude all issuers involved in thermal coal but ended up investing in bonds from Russia’s largest coal miner, Siberian Coal Energy Company (SUEK).

This happened as the ETF’s index, the JP Morgan ESG CEMBI Broad Diversified Custom Maturity index and its data provider, Sustainalytics, gave the Irish vehicle issuing the bonds – called SUEK Securities – an average ESG rating rather than the rating of the parent company.

“This is an example of how such companies can appear in fixed income ESG indices. Historically, it has been about how to integrate ESG within equity funds and ETFs,” Mielnik said. “Index and ETF issuers tried to replicate the same model for fixed income but there were things missing.”

She suggested in fixed income ESG, ETF issuers and index providers need to do more look-through on corporate bond issuance and have staff with bond-specific expertise.

“All it takes to avoid these loopholes is having the expertise within the team and accounting for the complexities of the fixed income market – the guarantors of the bond, how the money flows and how the structures are set up. These are factors index and data providers need to account for.”

Room for bad actors in ESG bonds?

Addressing the argument that bad actors belong in ESG so asset managers can engage them, Mielnik warned that in broad ETFs with a thousand or more constituents, there is unlikely to be high levels of engagement with companies.

“I am yet to see any solid engagement reports with proof of results of engagement with these companies,” she said. “There are active managers doing a great job on engagement but in the passive space, with so many companies, it is more difficult.”

However, she concluded the opportunity for engagement in fixed income is often underappreciated – there are far more bond issuances than IPOs.

“The number of issuances is high as you have companies with bonds maturing and then they refinance by issuing new bonds, so usually that is an opportunity for investors to engage. When companies approach their investor base, they can make the decision whether to buy the new bond being issued.”

This article was first published inFixed Income Unlocked: After The Storm, an ETF Stream report

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