ESG Derivatives - the quest for the right methodology
Demand to manage and hedge sustainability exposure is growing
Last March, Eurex broadened its offering, giving market participants the ability to hedge and trade futures on ESG equity benchmarks. Five regional and global MSCI ESG equity benchmarks focused on excluding ESG laggards were added. The move is a direct response to growth in ESG investment and the ensuing demand to hedge and manage that sustainability exposure – particularly in today’s challenging markets.
“ESG is a consistent theme with our members. Investors are increasingly excluding companies from their portfolios and we wanted to create standardization in futures trading,” said Christine Heyde, Equity and Index Product Design at Eurex. Speaking during a recent webinar hosted by Responsible Investor, Heyde detailed the motivation and key considerations that have guided the most recent roll out of ESG derivatives on the exchange, with additional expert comment from executives at index provider MSCI, and one of Scandinavia’s largest asset managers, Swedbank Robur.
Creating a complete solution
The move is a direct response to client demand. Magnus Linder, Head of Derivatives at Swedbank Robur, explained challenges the asset manager has faced because of the lack of exchange traded, ESG compliant derivatives. “When I talked to people in the market, we couldn’t buy anything delta one listed that was ESG compliant. We were in danger of selling products to our customers that weren’t what they thought they’d bought,” he recalled , adding that ESG derivatives now allow Swedbank to efficiently manage inflows and outflows by remaining fully invested without compromising on clients’ ESG exposure. “We have our core holdings in the basket and on top of this we buy or sell ESG futures to handle all the inflows and outflows accordingly. We are selling a product to our client that is fully ESG and fully invested with little, or no, tracking error.”
“ESG derivatives now allow Swedbank to efficiently manage inflows and outflows by remaining fully invested without compromising on clients’ ESG exposure.”Magnus Linder, Head of Derivatives at Swedbank Robur
Step one on the ESG integration journey
Eurex is deliberately developing its MSCI ESG futures offering on underlying entry-level MSCI screened indexes (World, EM, US, EAFE and Japan). MSCI offers multiple indexes, crafted by in-country expert teams with analysis focused on the extent to which ESG risk impacts a company’s business and earnings. Screened indexes based on an exclusion methodology that takes out the worst ESG offenders from the parent index (think controversial weapons companies, tobacco manufacturers, companies deriving revenues from thermal coal and companies that breached the UN Global Compact Principles) reflect investors’ most common concerns. ESG screens are easy to understand and increasingly well-known. “We learnt that simplicity wins,” said Heyde. “Investors are aware of these benchmark indexes, and futures offer what clients want around ESG and financial performance.”
MSCI’s screened indexes also offer a good fit with European buy-side clients’ demands for liquid, low cost benchmarks with standardized exclusions, she said. Moreover, screened indexes speak to asset owners’ increasing fiduciary priority to go beyond traditional market cap indexes to implement ESG. “The effectiveness of screened indexes in reducing exposure to carbon and stranded assets stands out,” she says. “If you compare the MSCI World Index and the MSCI screened version, you can see there is a lower carbon footprint.”
Assessing performance and costs
Like Linder, Heyde also lauded the minimum tracking error (around 50bps) of screened indexes. A point MSCI webinar panellists Guido Giese, Executive Director, Core Equity Research and Vasileios Koutsoulis, Executive Director, Index Derivatives Products, explained further, adding that tracking errors typically increase with the higher level of ESG integration that comes with more complex ESG indexes which can add in tilts to companies with stronger ESG scores. Importantly, MSCI’s screened indexes have all performed strongly in today’s challenging market. “Our indices have outperformed quite noticeably in the last three months,” said Giese. He listed screened indexes’ reduced exposure to oil sands and coal, or equity style tilts in the more sophisticated indexes, as factors contributing to outperformance.
“MSCI ESG indices have outperformed quite noticeably in the last three months.”Guido Giese, Executive Director, Core Equity Research at MSCI
Derivatives also have cost benefits, participants heard. It is cheaper trading the future than trading the basket of securities, explained Linder. Under pressure to reduce trading costs and hit ESG goals, Linder worked with Swedbank’s clearing brokers and custody department to gauge the fee differential in a process that tallied the back office and operational costs involved in both transactions. “If you trade more than one stock, it’s cheaper to trade the future,” he said. “We have a tendency to focus on transaction fees and spread costs, and not look at what is happening after we’ve booked the trade – but costs continue after pressing the button.” He added that active strategies and engagement can also run alongside ESG integration in derivatives. “These are not mutually exclusive approaches,” he said.
Graphic 1: Live polling results
A live audience poll conducted at a recent webinar hosted by Responsible Investor, suggested that 15 % of those polled are already trading ESG derivatives. One third answered ‘not yet’, implying a certain affinity for trading ESG derivatives in the future.
Building liquidity and investor confidence in MSCI ESG futures is now the priority, said Heyde. “ESG is not yet always as liquid as traditional benchmarks,” flagged Linder. “Market makers don’t like trading with themselves. When you have real buy-side clients it improves the market quite dramatically.” Eurex estimates that there are over 40 buy-side firms active on MSCI products, while an additional 85 firms are waiting in the wings for liquidity to improve further. In encouraging signs of growing liquidity across other indexes, Heyde said derivatives on four STOXX ESG indexes launched last year now have over 1.1m contracts traded and around €15 bn in notional traded.
She is confident Eurex has chosen the right underlying indexes to nurture liquidity, picking benchmarks with the most volume to offer ESG derivatives against. “We’ve found that liquidity and open interest accumulate in this exclusion methodology. The five futures we picked account for around 50% of traded volume of MSCI derivatives.” Moreover, she said it is an easy benchmark for asset owners to incorporate, and for Eurex’s liquidity providers to price. “Our liquidity providers have easily incorporated this index to price benchmark futures and provide on screen price provision,” she said.
“When you have real buy-side clients it improves the market quite dramatically.”
Magnus Linder, Head of Derivatives at Swedbank Robur
The future of ESG integration in derivatives
As to what lies ahead, Eurex wants to offer its clients the greatest possible flexibility in ESG investments. Expanding its offering beyond futures on straightforward screened indexes to incorporate more sophisticated underlying methodologies would be a next logical step. Futures on MSCI’s Universal Index family which has the basic screen but also incorporates linear tilts to highly rated ESG corporates would be one example. “From our entry level it should be possible to switch to more ESG compliant indexes,” said Heyde. Different indexes allow investors to choose their own level of trade-off between the tracking error, ESG score and market coverage, explained Giese. “Investors have different priorities. Some want to be really close to the benchmark with no tracking error, but others have a higher appetite for ESG.”
In a final trend, participants heard how even basic indexes are set to offer greater depth as investors seek to exclude more companies in the transition to fossil free. Regulation like the EU’s Green Taxonomy will drive behaviour and could also help standardize data and ratings methodologies, easing the move to more complex indexes beyond straightforward exclusion. “We will continue to partner with leading ESG index providers and consult with our European clients in response to this new investment behaviour,” concluded Heyde.
 Delta one refers to financial derivatives that have no optionality and as such have a delta of (or very close to) one – meaning that for a given instantaneous move in the price of the underlying asset there is expected to be an identical move in the price of the derivative.