Do investors have to sacrifice return to follow environmental, social, and governance (ESG) principles? That question is at the heart of the ESG debate, and is one that Martin Fridson, CIO of Lehmann, Livian, Fridson Advisors, has attempted to answer through ongoing research of the topic. However, his most recent findings are likely to disappoint investors on both sides of the issue.
Fridson’s analysis, which centers on the high-yield bond market, attempts to identify a residual ESG-related effect in the March returns of three high-yield ESG-based indexes: the ICE US High Yield ESG Tilt Index, the ICE US High Yield Duration-Matched ESG Tilt Index, and the ICE US High Yield Best-in-Class ESG Index.
The research, which was published by S&P Global Market Intelligence, looked at the selection process of the ESG Tilt and Duration-Matched ESG Tilt indexes, and found that they incorporate ESG objectives only by excluding bonds of issuers with significant exposure to controversial weapons, such as anti-personnel mines, nuclear weapons, cluster weapons, biological and chemical weapons, depleted uranium, and white phosphorus munitions. The analysis also focused on bonds with favorable ESG scores, as determined by Sustainalytics, and that are included in the best-in-class index, while those with unfavorable ESG scores are excluded. Fridson refers to the two categories as “bad citizens” and “good citizens.”
Fridson’s research found that the good citizens outperformed ESG bad citizens during the March sell-off by a statistically significant margin of 1.68 percentage points. But there is wrinkle to that.
“On the face of it, high-yield investors were actually rewarded for high-mindedly restricting their holdings to bonds of companies with commendable environmental, social, and governance practices,” said the report. “Examination of the underlying data casts doubt on that conclusion, however.”
Fridson’s findings suggest that the reason the good citizens outperformed the bad ones had more to do with the fact that they had higher ratings. The report notes that 12.7% of the bad citizens were rated CCC1 or lower, compared with only 4.1% for the good citizens.
High-yield investors “need not sacrifice return to adhere to investment rules that exclude bonds of issuers they find objectionable on environmental, social, and governance grounds,” said the report. However, it also said that the findings “do not support, in the case of high-yield bonds, the contention of some proponents that concentrating on issues with favorable ESG scores increases investment performance.”
The report said that if issuers without significant involvement in controversial weapons, or that have favorable ESG scores, are inherently less risky than like-rated issuers that lack those characteristics, the bonds should beat the conventional high-yield index “most handily” in periods of sharply rising risk aversion. However, the research found no statistically significant performance differential that could be attributed to ESG factors.
“We conclude that high-yield investors are neither rewarded nor penalized for being on the side of the angels on a full array of environmental, social, and governance matters,” said the report.