Regulation Spurs Sustainable Bond Fund Demand in Europe

Cost and performance drivers also key factors in growth of ESG bond and equity funds, say new studies.

Demand for sustainable UCITS bond funds is far outstripping that for traditional vehicles, according to a new report from the European Fund and Asset Management Association (EFAMA), driven partly by regulatory change in Europe.

Last year, sustainable bond funds saw €102 billion in net inflows in Europe, exceeding non-ESG bond funds, which attracted €69 billion, for the first time. With net assets of €621 billion at the end of 2021, sustainable bonds account for around 20% of all UCITS bond fund assets.

Over the decade to 2021, the net assets of sustainable bond funds grew by 291%, EFAMA noted.

EFAMA Senior Economist Vera Jotanovic said the supply and demand drivers of sustainable bond fund inflows were being supported by regulatory developments, notably the introduction of the Sustainable Finance Disclosures Regulation (SFDR) and the EU Taxonomy.

“Policy developments will help future growth by providing greater clarity to the market. The goal should be to ensure that asset managers have all the data needed to fulfil regulatory requirements by aligning with the taxonomy and to ensure that investors are investing in sustainable funds validated by regulators and avoiding greenwashing,” she said.

At present, there is considerable diversity among sustainable bond funds in Europe, with some existing funds being rebranded to meet SFDR Article 8 or 9 requirements, while others were launched with a specific sustainability focus to meet the regulation’s criteria. Further, there is divergence between the investment strategies of funds, with some managers taking a broader view of the sustainable bond universe than others.

As part of existing regulatory processes, asset managers will be expected to provide more information to investors about the contents and processes underlying their sustainable fund offerings.

Jotanovic suggested that further alignment with regulatory requirements by asset managers would help investors to better evaluate and distinguish between sustainable bond funds.

“Asset managers are trying to be diligent in the reporting of their investment processes, but we expect greater transparency and clarity to result from the policy developments in the future,” she added.

EFAMA intends to conduct further analysis of the portfolio composition of sustainable bond funds, as well as their resilience in volatile markets.

Value for money

At least part of the appeal of sustainable bond funds is value for money. According to EFAMA, EU-registered sustainable bond funds have consistently recorded higher risk-adjusted returns than traditional UCITS bond funds. Over the last five years, sustainable bond funds have a higher Sharpe ratio (0.47) than traditional funds (0.38), the study showed.

At the same time, prices have fallen, driven partly by intensifying competition. The average cost of sustainable bond funds has “consistently declined” since 2017, EFAMA found, reaching 0.59% in 2021, lower than the average 0.76% costs for traditional bond funds.

However, sustainable bond funds have delivered slightly lower average gross annual returns than traditional bond funds during the last decade, outperforming only in 2020, amid the market turbulence caused by the global pandemic, largely due to their limited exposure to the non-renewable energy.

As well as typically holding bonds with higher credit ratings than the typical traditional bond fund, sustainable bond funds tend to hold a higher proportion of shorter maturity debt instruments, i.e. up to three years. Their lower exposure to longer-dated issues overall means they are less sensitive to interest rate risk. In average, EFAMA found that sustainable bond funds held a large share of corporate bonds (61%) followed by government bonds (22%).

For the report, EFAMA conducted an analysis of Morningstar Direct’s database, containing funds available to both retail and institutional investors, and relied on Morningstar’s definition of sustainable bond funds as those which explicitly indicate use of sustainability, impact, or ESG strategy in their prospectus or offering documents.

The database contained 1,411 sustainable bond funds at the end of 2020, compared to 4,548 traditional bond funds. Eighty-four percent of the funds analysed were categorised as Article 8 funds under SFDR, while 11% represented Article 9 funds, and the remaining 5% were not classified.

Equity fund outperformance

A separate recent study of UCITS equity funds by the European Securities and Markets Authority (ESMA) reported that sustainability-focused funds were increasingly attractive to investors, in terms of lower costs and higher returns, compared with traditional funds, during 2019 and 2020.

Earlier this week, ESMA published new research which found that ESG equity funds were cheaper and better performers than non-ESG peers, even when controlling for factors including the former’s orientation toward large cap stocks and developed economies, as well as accounting for differing sectoral exposures.

ESMA found that, all else being equal, an ESG fund “appears less expensive” than a non-ESG fund by 0.080 percentage points over the period April 2019 to September 2021.

The ESMA study also included a variable to distinguish between funds created initially with an ESG focus and those which only integrated ESG processes and principles later, e.g. for categorization under SFDR, finding that the former had lower ongoing costs.

“In a context of strong interest for costs and performance of investment funds and exponential growth of the ESG market, the specific issue of costs and performance of ESG funds is of primary interest from an investor protection angle,” said ESMA.

The sample included both retail and institutional funds, finding that institutional funds typically have lower ongoing costs compared to retail funds, but with similar monthly gross performance. ESMA said further research would be needed to identify the other factors driving cost and performance differences.

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