Synthetic ESG Indices: Growing Investor Appetite Drives Innovation

Long-Term Risk and Reward

Simon Bentley looks at ESG and passive synthetic equity exposure

Environmental Social and Governance (ESG) considerations remain at the forefront of investors’ minds, because of the combined push of regulation, and pull of finessing long-term risk and reward outcomes. At the same time, synthetic or derivative based equity exposure has been a cornerstone of many institutional investors’ growth allocations for several years, as it offers low cost, capital efficient exposure. We have historically created such exposure using derivatives that reference traditional market cap indices. However, over the last few years we have seen increased demand for using derivatives that reference ESG tilted indices. This note explains how we can create ESG tilted synthetic equity exposure, the pros and cons of doing so, as well as setting out thoughts as to how this market may evolve.

We’ve previously discussed the evolving market for ESG and passive synthetic equity exposure, which you can read here.

Creating ESG tilted equity exposure

There has been a huge proliferation of ESG tilted indices, some generic in nature and others very specialist. When thinking of synthetic exposure, we must also consider the implementation practicalities and, in particular, liquidity, dealing costs and flexibility. When we do this, the universe of relevant indices narrows relatively quickly. When creating currency hedged exposure, we would typically prefer using futures referencing a basket of regional indices, denominated in local currency. This minimises costs, maximises liquidity and avoids any meaningful non-sterling currency exposure. However, when it comes to ESG tilted indices the range of available futures is not optimal. Firstly, it is difficult to create a basket that comprises indices from a single index provider, giving rise to a mix and match of ESG methodologies. Additionally, a lot of indices are either aimed at non-UK investors and therefore complicate the currency position or have very little open interest.

For these reasons, a total return swap on a global index has been the preferred way to deliver the desired exposure, with the MSCI World ESG Leaders Index being the go-to index within the market. Historically only available on a currency unhedged basis, we were pioneering in arranging for the publication of a sterling currency hedged version of the index and in securing the commitment of numerous banks to price against the index. The index excludes companies involved in obvious sin sectors (e.g. tobacco, civilian firearms, gambling, fossil fuel extraction, thermal coal power, weapons and nuclear power), filters out companies with poor controversy scores and then takes the highest 50% ESG scoring names in each sector. This results in an index with similar sector allocations to the parent MSCI universe, and therefore relatively low tracking error to the MSCI World Index. There is also a UK sub-index, allowing investors to tailor not just the level of currency hedging but the global vs UK mix of their exposure.

Market developments

Liquidity is developing in other indices as well, albeit they are typically MSCI indices, with some of these other indices offering a specific carbon tilt rather than just a generalist ESG tilt. These indices include the MSCI World ESG Screened Index, the MSCI World Low Carbon Target Index and the MSCI World Low Carbon Leaders Index. Pricing suggests that liquidity currently declines as one works through the list in order, but competitive pricing can be obtained for all with typical trade size of up to £300m for all but the latter index where £100m is more realistic. Each index requires some sunk set-up costs for a bank to be able to price it (data licensing costs amongst other things) so it is likely that the market will continue to focus on a limited number of go-to indices rather than proliferating endless variations, but this is no different to the traditional market. We also expect the futures market to expand both in terms of trade volumes and the availability of UK investor appropriate indices. Therefore, our “preferred approach” may well be different in 12 months’ time.

Pooled funds

So far, we have implemented numerous tranches of exposure within our segregated/bespoke fund client book but have been asked repeatedly whether a pooled fund would be feasible. As such, we have developed a specification for a daily dealt fund which provides leveraged ESG tilted synthetic equity exposure and would be pleased to discuss this in more detail if it is of interest.

It is worth reminding readers that synthetic exposure does not confer ownership rights in the same way as physical holdings do, so you do not have the ability to vote or engage with investee companies on ESG related topics. However, synthetic exposure does allow you to align exposure to your ESG beliefs and, clearly, exposure of any form, has a knock-on effect to asset prices, therefore rewarding companies with strong ESG credentials vs those without, over the long term.

Bond exposure

Finally, as a relevant aside, we are seeing the emergence of ESG tilted bond futures, allowing investors to create ESG tilted exposure to sovereign bond and corporate bond indices. This market remains in its infancy, for example, there is a futures contract traded on Eurex to provide exposure to euro denominated corporate bonds, but, as yet nothing similar for dollar or sterling bonds. That said, liquidity is already reasonable, albeit appropriate for medium to long term positioning rather than short term positioning. As such, trade sizes of c. £200m are realistic and with the most common use case being hedging existing exposure, pricing is currently attractive for those wanting to go long of bond exposure.

Please get in touch with your usual contact if you would like to discuss any of these topics in more detail.

The funds or securities referred to herein are not sponsored, endorsed, issued, sold or promoted by MSCI, and MSCI bears no liability with respect to any funds or securities or any index on which such funds or securities are based. The prospectus contains a more detailed description of the limited relationship MSCI has with BMO Asset Management Limited and any related funds.

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