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Friday View: 16 December 2016

Do portfolio screens affect your bond portfolio’s performance?

Do portfolio screens affect your bond portfolio’s performance?

By Joshua Kendall
Friday 16th December 2016

Many investors screen sectors or companies out of their portfolios. This might be driven by an organisation’s charter, regulatory requirements, reputational concerns, or the view that some activities are unethical.

A key question is how such screens affect investment returns. There is a large body of research focusing on screened equity portfolios, but very little has been written about fixed income. We find this surprising given the importance of fixed income for many institutional investors.

A research paper from Insight analysed how portfolio exclusions affect investment grade and high yield fixed income benchmarks over the past decade. We discovered that broad screens have had a minimal effect on long-term returns, but more focused screens targeting fossil fuels have had a larger impact.

Our analysis

We chose two investment grade and two high yield Barclays indices, with one of each being denominated in euros and the other in US dollars. We aimed for broadly comparable mainstream indices, with multiple bond durations, maturities, quality and type.

We applied two distinct screens to these benchmarks. The first, a broad ethical screen, excluded companies in the aerospace/defence, tobacco, gaming, and food and beverage (including companies that produce wine, spirits and beer) sectors. The second applied a fossil fuel screen, which excluded companies in energy-related sectors widely considered to be most affected by fossil fuel regulations and subject to calls for divestment. We also included companies involved in pipelines as these would be highly likely to be affected by changes in fossil fuel production or consumption.

The results showed that over the 10 years to 30 June 2016, the ethical screens had a modest effect on the benchmarks’ performance. The fossil fuel screen had a moderate effect on the two investment grade indices and on the high yield euro-denominated index. However, it had a significant positive effect on the high yield US dollar-denominated index. We found that most of the outperformance occurred from late 2014 through to the end of the period, reflecting a significant decline in the oil price.

Wider reflections

These results led us to three wider conclusions. First, there are no practical barriers to applying ethical exclusions to fixed income portfolios. It is primarily a question of identifying the issuers to be excluded and then applying the exclusions.

Second, the effect of traditional ethical exclusions appears likely to be modest. This is important because much of the literature on the investment effects of screening does not focus on the magnitude of the impact but instead seeks to assess its direction, and to discover whether excluding issuers reduces specific risks, reduces diversification, or reduces the likelihood of outperformance. These are important questions, but our analysis suggests the impact – in either direction – is not likely to be material.

The final conclusion is that the direction of the performance impact cannot be predicted. For example, our analysis suggests that excluding fossil fuels would have enhanced performance in US high yield portfolios over the past decade. But this was a direct result of the recent fall in the oil price. Looking forward, the reverse might apply, with rising oil prices leading the sector to materially outperform.

Difficult questions

The impact of screens on performance is an important issue for investors, but practical questions remain.

In recent years, environmental, social and governance (ESG) research providers have broadened their scope. There is now good coverage of investment grade issuers, but only partial coverage of high yield issuers, meaning there is often a need to conduct detailed analysis to assess whether a high yield issuer fulfils the criteria set out by an investment screen.

Another challenge relates to the interpretation of investors’ exclusion lists. If an investor wishes to exclude investments in a tobacco manufacturer, is it acceptable to include a company that sells tobacco products? Similarly, the definition of an ethical investment differs between countries. For example, while some of our German clients exclude nuclear power from their portfolios, nuclear power tends to be looked upon favourably by our French clients.

These challenges mean that applying effective portfolio screens to fixed income investments require analysis and detailed client engagement, primarily to establish a suitable universe of investable securities.

Insight’s research addresses questions our clients and institutional investors are starting to consider. We believe there are significant opportunities for responsible investment strategies in fixed income and expect to support more investors with relatable investments to meet their long-term objectives.

Joshua Kendall is an ESG analyst at Insight Investment

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Friday View

Friday View

16 December 2016

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