Join our community of smart investors

iShares moves into ethical bond space

We explore whether ethical bonds meet investors needs
January 19, 2016

The number of ethical bond exchange-traded funds (ETF) based in the UK has doubled – although only to two.

But entry into the space by ETF behemoth iShares could signal a future boom in the size of the market. The iShares Euro Corporate Bond Sustainability Screened 0-3yr UCITS ETF (SUSE) tracks an index comprised of bonds that meet the criteria of an ethical screen. But just how ethical are the holdings and why are there so few ETFs in this space?

 

How is an ethical bond ETF constructed?

The iShares product and its only other UK-based peer in this space - the UBS ETF Barclays MSCI US Liquid Corporates Sustainable UCITS ETF (UC97) – track two different ethical indices devised by MSCI and Barclays. The indices are compiled using a two-stage process of positive and negative screening to whittle down the most ethical bond issuers. MSCI begins by grading a list of companies based on their environmental, social and governance (ESG) qualities (defined by MSCI in a ratings system ranging from AAA to CCC). Companies are given a grade based on a range of criteria, including their carbon footprint, health and safety standards and business ethics. After that, companies engaging in certain businesses are excluded from the list. Different ethical indices exclude different types of companies.

The iShares fund tracks the Barclays MSCI Euro Corporate 0-3 year Sustainability ex-Controversial Weapons index, a benchmark made up of investment-grade corporate bonds. The index accepts only corporate bond issuers meeting MSCI’s ESG score of BBB or higher and negatively screens for any issuer involved in controversial weapons, such as landmine manufacturing and depleted uranium weapons. But this method of compiling the index does mean a large number of banks and natural gas companies reside in it, which might not be everyone’s definition of ethical.

The UBS fund tracks a different index. This also prioritises ESG grades of BBB or higher and excludes issuers involved in tobacco, gambling, adult entertainment, nuclear power and other industries.

How ethical are the funds?

The word ethical encompasses a broad church of definitions. Adam Laird, head of passive investing at Hargreaves Lansdown, says: “Ethical investing is such an individual matter. It’s impossible for one set of rules to fit everyone. The iShares bond ETF looks at a range of ESG considerations, but these won’t meet everyone’s criteria.”

A case in point is the iShares ETF’s exposure to airport operator BAA Funding, which is included in spite of energy, carbon and pollution screens. In the case of UBS, the ETF includes a large number of banks and pharmaceutical companies.

 

Are ethical ETFs transparent?

The new breed of sustainable ETFs have made significant progress in terms of displaying their full holdings compared with mutual funds, which have been heavily criticised for a lack of transparency.

An issue is the lack of a Europe-wide set of rules, which means products marketed in the UK as ethical or socially responsible would be unable to operate in, for example, Belgium and France due to more stringent regulation in those countries, which demand full disclosure of holdings.

Unlike most mutual funds, both iShares and UBS display all of the portfolio holdings of all their ETFs and update these daily. However, ETF providers are not actually required to disclose full lists of holdings under Ucits regulations and index providers are also not required to reveal to investors a full list of portfolio holdings. Sources at the London Stock Exchange and MSCI argue that revealing the full holdings of an index would hinder their competitive advantage.

Why are there so few ethical ETFs?

MSCI has four different ESG indices for bonds and four for equities, but providers have not flocked to list ETFs on the London Stock Exchange. There has been more progress with equities, where products in the UK include ETFs such as UBS MSCI Emerging Markets Socially Responsible UCITs ETF (UC79), but progress in the bond world remains sluggish.

A spokesperson for MSCI says: “There is not a great consensus in terms of what ESG actually means and how to define it. It’s not only the industry trying to get to grips with it, clients are too. Some want a generic sustainable product, but others want to exclude specific things. The requirements from clients are diverse so it’s not easy to build products based on demand.”

That has not stopped the trend flourishing overseas, though. According to MSCI, equity ETF assets tracking MSCI ESG indices grew nearly 30 per cent to $1.8bn between the start of 2015 and July and since December 2013 assets more than doubled, rising by 140 per cent, with 22 new ESG ETFs tracking MSCI indices.

 

The top 10 holdings of the iShares and UBS ethical bond ETFs

iShares Euro Corporate Bond Sustainability Screened 0-3yr UCITS ETF

IssuerExposure
Co-operative Rabobank UA4.6
BNP Paribas SA2.6
ING Bank NV2.5
Intesa Sanpaolo SAU2.3
Telefónica Emisiones SAU2.3
GE Capital European Funding2.1
Morgan Stanley 1.8
Santander International Debt SA Unipersonal1.6
Engie SA 1.6
Banque Federative Du Credit Mutuel SA 1.5

Source: iShares.co.uk, as at 11 January 2016

 

UBS ETF Barclays MSCI US Liquid Corporates Sustainable Ucits ETF

IssuerExposure
CCO Safari 7.7
Merck & Co5.7
Cisco Systems Inc 4.7
Intel Corp4.4
Celgene Corp 3.4
Intel Corp3.3
CCO Safari II 3.1
Hewlett-Packard Enterprise 3.0
Merck & Co2.7
HJ Heinz2.5

Source: UBS, as at 11 January 2016