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There’s a socially conscious fund that’s providing some stability at a time when broader market volatility reigns supreme — and rates continue to rise. The Invesco Floating Rate ESG Fund (AFRYX) last year shed just 2.25% on a total return basis, per Morningstar. Meanwhile, while the S & P 500 tumbled nearly 20% last year. The fund’s return was better than 51% of those in the same Morningstar category of U.S. bank loan funds, according to the firm’s data. The fund is lagging the S & P 500 year to date, gaining just 1.7% while the broader market index is up 4%. Still, the fund has posted positive returns in eight of the last 10 year. Its trailing 10-year return also outpaces 82% of other funds in the same category, Morningstar data show. The retail investor-focused AFRYX, which charges a fee of 0.81% and has a minimum investment of $1,000, is also the first floating-rate fund to screen for environment, social and governance factors, Invesco said. The fund began running ESG screens in 2015, though it wasn’t formally integrated into the ESG process until August 2020, according to Morningstar. It also has more than $2 billion in assets and is rated four stars by Morningstar. How it works The fund looks for returns in the debts of large companies, specifically in floating rate bonds. These are bonds with fluctuating interest payments. The fund’s floating-rate nature allows it to be more nimble in times like these, when interest rates are rising. The Federal Reserve on Wednesday hiked rates by 25 basis points. And, while Chairman Jerome Powell acknowledged that credit conditions are tightening, he noted that the central bank has no plans of cutting rates soon. Under normal circumstances, at least 80% of the fund’s net assets and any additional borrowings used for investments are placed in senior secured floating rate loans from banks or other lenders, or senior secured floating rate debt instruments. Senior secured is a term used to describe short-term debt obligations. In other words, the lion’s share of the fund is in short-term bonds that have floating interest rates. The fund can also look elsewhere, including in “junk bonds,” or floating rate debt securities that aren’t considered investment grade, and subordinated loans, which are only paid off after primary loans. Up to 20% of holdings can be in other types of debt or stocks, which Invesco said is done in part to increase yield and cash flow. Biggest holdings While those are possible alternatives, the current holdings more closely reflect the mission of the fund. Senior secured loans made up 90.5% of the fund’s investments as of the end of 2022. Corporate debt bonds made up 6.3%, while U.S. common stocks were 1.6%. All other types of holdings made up less than 1% each. In the fourth quarter of 2022, the biggest holding, MLN US, was one of the top contributors by relative return, Invesco said. Sigma and H-Food, which were both not among the fund’s 10 biggest holdings, also performed well. On the other hand, small holdings such as Crown Finance US, the eighth-biggest holding, was one of the worst performers in the quarter, along with Avaya and Vue International. Relative stability Morningstar said the fund has returned mixed results during periods of market stress, though it has performed better in recent years. The fund outperformed 90% of peers in 2021 due to the managers’ ability to avoid hard-hit loans its focus on lower-quality, single-B grade loans that rallied as the economy came out of its Covid-induced slowdown in 2020. It’s also relatively stable, with the fund never losing any more than 10% in a year, according to data from FactSet. Meanwhile, over the same period, the broader market grew over the 2010s and then saw a jump during the pandemic before tumbling last year. But the fund has underperformed while the market surged. For example, the fund’s gained just over 2% in 2021 while the S & P 500 jumped nearly 27%, per FactSet. There are also risks with this strategy, Invesco noted. Many senior loans are illiquid, meaning they can’t always be sold quickly or at a fair price. And the market for illiquid securities is considered more volatile than the liquid market, with the added risk of default if companies fail. The role of ESG The portfolio managers complete a due diligence review of each potential holding that typically include in-depth meetings with the issuer’s management team, financial sponsor and third party experts to better assess risk and how it fits into broader industry context. But portfolio managers first employ an ESG screen to exclude any potential issuers that don’t meet its socially conscious criteria. Qualities that would exclude an issuer, according to Invesco, include those with “substantial involvement” in tobacco production and thermal coal. As a broader rule, issues are excluded if they don’t comply with the United Nations’ global compact principles . Each potential investment is scored on a scale of one to five — with one indicating no risk and five indicating high risk — for how it aligns in environment, social and governance principles. Here are some of the factors the managers look for in each portfolio: Environment: impact to natural resources, pollution and waste and supply chains Social: workforce, community, product responsibility and human rights Governance: management, shareholders, board of directors, auditors, regulatory issuers, corporate social responsibility strategy, anti-corruption and business ethics Each investment is then assigned a weighted average score for each pillar and a composite score, with each of the pillars weighted differently within the composite depending on the industry. The fund will not invest in anything that falls below an internal level set for either one or more pillars, the composite and will divest from any that fall below those levels over time. Invesco wouldn’t make the fund manager, Thomas Ewald, available for comment.
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