ESG in High Yield: Shortcuts Versus Thoughtful Integration

Posted on July 13, 2021

In April 2019, DDJ published a white paper titled ESG in High Yield: Beginning of a Journey, in which we described DDJ’s multi-year journey integrating ESG into our research and portfolio management process. In the final part of that paper, we contemplated where that journey might take us next, anticipating that a likely direction would be the development of a dedicated ESG strategy focused on environmental sustainability.

In June 2020, we did exactly that, launching DDJ’s Environmental Sustainability High Yield Strategy via a simulated portfolio.In this blog, we will not describe the strategy in detail, but instead ask a broader question, which we inevitably had to ask ourselves in the process of developing the strategy. That question is “Can an ESG-focused high yield investment strategy deliver on its ESG objectives?”

After all, there are plenty of arguments against it. For example, there is inconclusive evidence that ESG integration enhances investment returns, with substantial data supporting both sides of the argument. Stakeholder engagement, which can be an effective tool to drive change at the individual issuer level, can be more challenging for debt holders  rather than shareholders, of a company. In addition, because many high yield issuers tend to be smaller, often privately-owned companies that lack the resources (or desire) to publish glossy sustainability reports, ESG data for many high yield issuers remains difficult to obtain.

DDJ believes that many high yield managers, facing increasing pressure from their clients for greater integration of ESG in the management of their portfolios, take shortcuts in an effort to accomplish this objective. One shortcut is to rely solely on third-party ESG rating providers, such as MSCI or Sustainalytics, filter out all lower-rated issuers, and, voilà, an “ESG” portfolio has been created. Another shortcut might involve hiring an ESG analyst who is assigned to cover and rate hundreds of issuers across multiple asset classes, with these internal ratings used to define the investible universe. Both approaches suffer from similar drawbacks, the most important of which is having non-investment professionals with large coverage universes provide input that influences the investment decision-making process.

In order to have a truly nuanced view of the ESG considerations for any particular company, DDJ firmly believes that one must thoroughly understand both the company itself and its industry. A credit strategy that invests in hundreds of companies may not have the research bandwidth to form such a nuanced view with respect to any individual issuer. We have observed that even third-party ESG rating agencies that rate thousands of issuers miss some key differentiators. Similarly, an internal dedicated ESG analyst with broad coverage responsibilities may not have a thorough understanding of each individual business to truly integrate the various complexities of ESG into his or her analysis.

DDJ believes that this is one of the key reasons why research analysts responsible for recommending investments for their client portfolios should perform their own ESG research rather than “outsource” this responsibility either internally or externally. For example, DDJ’s research analysts, by design, cover fewer issuers than analysts at many of our peers and are tasked with conducting exhaustive, bottom-up fundamental research in order to thoroughly understand each issuer in which our client portfolios invest. For this reason, DDJ believes that our research process is well suited to facilitate in-depth ESG analysis by the individuals responsible for making each investment recommendation.

Interested in taking a deeper dive on ESG in the high yield space? The above post is an excerpt from our 2021 white paper, Dedicated ESG High Yield Strategies: Can They Achieve Their Objectives? We invite you to download your free copy of the white paper, available below. 

 

Dedicated ESG High Yield Strategies

 


1The DDJ Environmental Sustainability High Yield (“ESHY”) strategy was incepted on June 1, 2020. As of the date hereof, no actual client assets are invested in this strategy. Statistics are accordingly based on a simulated portfolio. DDJ has created the strategy’s track record through rules-based, ex-ante trading via the firm’s order management system, and follows, to the extent practicable, the processes of a portfolio that contains real assets. For example, when the simulated portfolio intends to participate in a transaction which is occurring in actual client portfolios managed by DDJ, it receives an allocation of the trade at the actual trade value. When the simulated portfolio trades a security for which there is no trade executed by DDJ-managed client accounts, the execution size and price is dictated by available TRACE activity on day of execution. Additional information regarding the rules with respect to the simulated portfolio is available upon request. There are certain limitations inherent in simulated model results like those portrayed, particularly that such simulated model returns do not reflect trading in actual client accounts and do not reflect the impact that material economic and market factors may have had on DDJ’s decision-making had DDJ actually been managing client funds. Such factors can adversely affect actual trading results (and, accordingly, affect the characteristics set forth on the factsheet).

The information and views expressed herein are provided for informational purposes only, and do not constitute investment advice, are not a guarantee of future performance, and are not intended as an offer or solicitation with respect to the purchase or sale of any security. The inclusion of particular investment(s) herein is not intended to represent, and should not be interpreted to imply, a past or current specific recommendation to purchase or sell an investment. Any projections, outlooks or estimates contained herein are forward-looking statements based upon specific assumptions and should not be construed as indicative of any actual events that have occurred or may occur. This material has been prepared using sources of information generally believed to be reliable; however, its accuracy is not guaranteed. Investing involves risk, including loss of principal. Investors should consider the investment objective, risks, charges and expenses carefully before investing with DDJ.

Past performance is no guarantee of future returns.