On the Factor Implications of Sustainable Investing in Fixed-Income Active Funds

Abstract

Interest in sustainable investing in fixed income has grown tremendously. A natural question concerns how environmental, social, and governance (ESG) attributes affect expected return and risk. Most evidence has focused on equities. In this article, the authors use quarterly holdings data for a broad sample of US fixed-income active mutual funds to attribute active returns to

• 1. the returns to static factor exposures;

• 2. time-varying factor exposures;

• 3. security selection.

They find that funds with strong ESG attributes derive a significant fraction of their alpha from static factor exposures, which reflects a tilt toward higher-quality bonds that are less volatile. This fact explains the strong negative relation between a fund’s total return and its holdings-based ESG score.

TOPICS: ESG investing, fixed-income portfolio management

Key Findings

• • A holdings-based analysis of active fixed-income mutual funds provides deep insight into the relation between ESG attributes and investment performance.

• • Funds whose holdings can be mapped to ESG attributes derive a significant fraction of their alpha from static factor exposures, reflecting the composition of their bond portfolios.

• • There is a strong negative relation between a fund’s total return and its holdings-based ESG score. This is explained by the fact that funds with higher ESG scores tilt toward higher quality; they hold higher-rated bonds that are less volatile. The composition of ESG scores matters, with environmental score most closely related to fund volatility.