DerivSource reporter, Lynn Strongin Dodds looks at how listed derivatives are embracing ESG and sustainability investing and the opportunities and challenges it brings
The environmental, social and governance (ESG) movement has taken hold in the equities sphere and it was only a matter of time before it moved across to fixed income and listed derivatives. Eurex and Nasdaq have launched ESG futures and others are expected to follow. However, it is still early days and challenges remain over the different definitions, lack of standards and varying markets structures.
The one thing that is certain is that adopting a greener approach is becoming embedded into mainstream fund management. Assets under management in ESG related strategies steadily climbed to $30 trillion last year, following a 25% increase to $24 trillion between 2014 and 2016, according to a recent Standard & Poor report – Exploring Links to Corporate Financial Performance.
A new and separate study from UBS Asset Management – “ESG: Do you, or don’t you?” confirms the trend with 78% of asset owners globally integrating ESG into their investment process. The survey which canvassed over 600 investors with over €19 trillion in combined AUM found the main drivers to be enhanced returns and better risk management. In fact, over 80% saw a material danger in not incorporating ESG factors into their decision-making while around 55% thought it would have a positive impact on financial performance. Moreover, participants expected environmental issues to be more material than traditional financial criteria over the next five years.
Not everyone though is moving at the same pace. The Dutch, French and Scandinavian institutional investors have been at the forefront while the US has been slower to take up the mantle. However, this is top of the agenda for the more socially conscious Gen-Z and millennial generation who want more sustainable products on their pension savings menu.
One of the main problems across the board is the lack of clarity around the various choices on the market. As James Purcell, Head of Sustainable and Impact Investing at UBS Global Wealth Management, notes “There is a degree of confusion over the terminology between the different strategies. For example, a fund may be labelled as impact investing when in fact it really is an ESG fund – they are two separate things. The industry would benefit from standardisation and clearer definitions across the industry.”
“There is a degree of confusion over the terminology between the different strategies. For example, a fund may be labelled as impact investing when in fact it really is an ESG fund – they are two separate things. The industry would benefit from standardisation and clearer definitions across the industry.” – James Purcell, head of sustainable and impact investing at UBS Global Wealth Management
Broadly speaking, an ESG framework is typically integrated into the risk-return analysis of investment opportunities based on company disclosures, government databases and other sources. Socially responsible investing takes it one step further and incorporate ethics and social concerns into portfolios. This can be done through negative screening based on moral, ethical or religious beliefs or positive screening – overweighting companies with strong ESG credentials. Impact investing, which has been popular in the private equity space, invests in companies that provide solutions to environmental or social challenges and through formal frameworks such as the UN Sustainable Development Goals (SDGs). Recently, it has been gaining traction in the listed equity arena.
Applying these concepts to fixed income and listed derivatives has been trickier although definitely possible. “There are very few barriers to entry in the equity world,” says Purcell. “In fixed income you need a different lens and the ability to cut the universe in a different way. There are also various political challenges but there has been growing interest in green bonds and the development of green indices.”
Fitch Ratings estimated that the assets of European green bond funds hit the €5.6bn mark at end-2018, up from about €3bn at the end of 2017. This 80% annual growth rate is in contrast to the 11% slide in broad European domiciled bond fund assets over the same period.
Statistics on ESG futures are thin on the ground because they are the new kids on the sustainable block. It was only last October that Nasdaq launched futures based on the OMXS30 ESG Responsible index which excludes companies that fail to meet ESG standards. Plans are underway for a corresponding ESG indices for two of its other Nordic benchmarks – the OMXC25 in Denmark and the OMXH25 in Finland.
More recently, in February, Eurex debuted the Stoxx Europe 600 ESG-X Index, a version of the large-cap Stoxx Europe 600 that screens out companies with low ESG rankings and the Euro Stoxx 50 Low Carbon Index based on the Euro Stoxx 50, the leading benchmark for continental European stock markets. It also introduced the Stoxx Europe Climate Impact Index, a group of roughly 260 European corporations that disclose the environmental impact of their businesses and excludes companies in industries such as coal.
Futures on the STOXX Europe 600 ESG-X are the most widely adopted so far, according to Vassilis Vergotis, Head of Equity & Index Strategy and Product Design at Eurex, who added that in the beginning of June open interest in the ESG futures reached €564m ($639m) since launch. “The exclusion methodology of the index allows investors to switch their portfolio to an ESG compliant benchmark with low cost and tracking error. We are moving into a new era where asset managers look at their portfolios under a different light and now consider climate impact or reputational risks. Our initial product offering considers indices developed from STOXX to provide a framework mitigating some of those risks.”
In March, the Commodity Futures Trading Commission (CFTC) gave the green light for the Eurex ESG contracts to be traded in the US. Vergotis believes that the level of interest among US asset owners will depend on their ESG investment strategies and geographic exposure of their portfolios.
In general, asset managers will be able to use the futures to create synthetic positions or to hedge their positions in the ESG universe. “They will also give asset managers more flexibility in managing the cash in ESG funds,” says Rick van Leeuwen, Head of Institutional Trading at IMC Trading. “Investors will now be able to hold a percentage of their portfolio in futures, thus enabling them to handle inflows and outflows in an efficient manner.”
He also notes using ESG futures will mean funds that need to employ them for their cash management will be ‘more’ ESG than before. “Funds that were already fully ESG but before didn’t have the ability to handle cash via futures and had to keep ‘cash’ on the balance sheet, will now be able to have 100% exposure in ESG equities,” he adds. “As a result, investors will now have the full opportunity to benefit from the relevant index performance.”
Isabelle Millat, Head of Sustainable Investment Solutions, Global Markets at Société Générale, which is a market maker in the Eurex ESG futures, also believes “they will add liquidity to the underlying indices and help align portfolios with a set of values. It also offers investors another type of investment solution that can drive performance and reduce risk.”
In the past there have been concerns over ESG targeted funds’ ability to deliver the investment goods. However, a meta-analysis of more than 2,000 primary studies of company behaviour from Friede & Busch concluded that there is a positive relationship between corporate financial performance and sustainability credentials. Other studies have found that ESG-focused companies tend to outshine peers in terms of both share prices and financial results. Since 1990, for example, the MSCI KLD 400 Social index, comprising companies with strong sustainability profiles and excluding laggards, generated annualised returns of 11.2% versus the S&P 500’s 10.7%.
This is not surprising given that these companies are typically less exposed to tail risks such as environmental accidents or punishment from regulators while robust ESG standards can act as a guide to a company’s overall quality of management and long-term sustainability.
However, as with any investment due diligence is required. “In the futures world, it boils down to picking the right equities,” says Millat. “One of the challenges is getting the right information. That is easier in equities and corporate credit than other fixed income instruments but I think it will expand to other asset classes as the industry matures. To me futures is one more piece of the puzzle and little by little almost all solutions should and will become available in an “ESG” version.”
van Leeuwen also believes there will be more products in the futures pipeline “ESG is a growing space, so I can imagine it could be just a matter of time before more exchanges/indexes offer ESG versions of the futures,” he says. “More broadly, the ESG market is already large as more investors move towards and ask for products that enable responsible investment. We have seen more ESG ETFs launched over the recent period and these funds have been gaining momentum.”
One of the stumbling blocks he notes is that at the moment is that there is still a slight difference in cost between ESG and ‘classic’ benchmark products. “When the ESG funds become more mainstream and the funds grow larger I expect the costs of these funds to also be at similar levels to the main benchmark funds,” he adds. “Perhaps one day the ESG version will become the standard tracking benchmark, but we are not there yet.”
