How evolving ESG indices & derivatives help transforming portfolios

Christine Heyde, Equity & Index Product Design, Eurex and Guido Giese, Executive Director, Core Equity Research, MSCI

Eurex only began offering market participants the ability to hedge and trade derivatives on five MSCI ESG Screened futures indexes (World, EM, US, EAFE and Japan) that exclude corporates not in compliance with the United Nations Global Compact principles or predefined ESG screening criteria in March. But they have quickly become a sought-after derivative product at the Frankfurt-based derivatives exchange as the number of investors seeking to integrate ESG to mitigate today’s most challenging risks jumps.

“Our overall Eurex ESG Screened index futures offering is approaching one million contracts traded this year amounting to €12bn of traded volume,” says Christine Heyde, Equity and Index Product Design at Eurex speaking during a recent webinar hosted by Responsible Investor. Eurex was the first to launch ESG derivatives on key benchmarks in Feb 2019.

Appetite for ESG listed derivative products is growing in tandem with wider investor demand to integrate ESG, most visible in the underlying spike in appetite for ESG ETFs, the best proxy for broad ESG investment, she says. “ESG ETFs reached a new milestone in July when AUM went beyond $100bn, over 50% of which is still domiciled in Europe,” she says, attributing growth to investor awareness of ESG and ensuing client demand, heightened by the pandemic, and regulatory pressure.


“Eurex ESG Screened index derivatives are approaching one million contracts traded this year amounting to €12bn of traded volume”

Christine Heyde, Equity & Index Product Design, Eurex


But perhaps the most important driver of growth in ESG and corresponding ESG derivatives – and cited as the number one reason for derivative take-up in a poll of webinar attendees – is risk mitigation. “Risk mitigation is an important aspect,” acknowledges Heyde, who references the ability to exclude Volkswagen from the Screened futures index as a typical example of ESG risk mitigation in action. Fast exit rules for breaking UN Global Compact stipulations over the diesel scandal meant the company dropped from the index, she explains. “In client communications we found out that  derivatives which are used for hedging purposes for a sustainable fund are not sufficient to be “nearly” ESG compliant; they are wanted to be fully compliant. If these companies are screened out in an automated way it really reduces risk for investors.”


Polling Question 1
Which of the following were motivations to include ESG analysis into your process?


“If you have derivatives which are used for hedging purposes for a sustainable fund you don’t want to be nearly ESG compliant; you want to be fully compliant.”

Christine Heyde, Equity & Index Product Design, Eurex 


Demand is also bolstered by the fact Screened derivative benchmarks have a proven, close relationships to the benchmark and easy integration into trading infrastructure. For example, performance analysis of the MSCI EM ESG Screened index reveals a slightly better return than the benchmark and a low tracking error “The tracking error is 0.6%, and the performance is similar or even better than the benchmark,” she says.


The benchmarks

The indexes that form the underlying for Eurex’s listed derivatives are built by MSCI’s 350 ESG specialists of which over 200 are expert analysts, dotted around the world and digging deep into the ESG credentials of every company in the index. “We cover every market with local language skills and know the local regulation,” says Guido Giese, Executive Director, Core Equity Research, MSCI.

Over the years, MSCI has developed three different sets of screens linked to different ESG objectives: traditional values-based screens which exclude well known culprits like thermal coal (something 72% of webinar respondents said should be screened out of indexes) and tobacco, or companies that break global norms like the UN Global Compact; positive impact screens which tilt towards impactful companies where corporate endeavour is linked to the SDGs, and so-called ratings screens which rate companies according to how ESG risk could impact their enterprise value and the risk return profile therein.

Regarding the latter, Giese explains how the ESG ratings process involves rating companies (using the same AAA to CCC guide as credit ratings) on ESG integration in a process unlinked to moral or ethical behaviour. “We simply measure how ESG risk can potentially impact the enterprise value of the company in a positive or negative way.” The process involves gauging companies against 35 key risks spanning labour practices to carbon or water stress and selecting those with the highest potential impact. “If you score a company on too many issues, the most relevant ones get diluted, so we only focus on the most material risks.”


“Screened Indexes – small steps for investors but a significant profile improvement for ESG”

Guido Giese, Executive Director, Core Equity Research, MSCI


Portfolio Construction

Armed with ratings information, portfolio construction begins. Each index starts with a market cap benchmark or a regional version. From this, MSCI’s most simple index ESG ‘Screen’ excludes the worst ESG offenders. A step up comes with ESG ‘Universal’ which also screens out laggards but takes the market benchmark and reweights companies, tilting to “good” companies and those that are trying to improve their ESG rating (even if off a low base) and away from companies with poor ESG scores. “Reweighting of the components means the best companies double their weight but those with a negative trend or low rating find their weighting cut in half,” he says. Another ESG ‘Focus’ index reweights but uses an optimiser to control for tracking error, while a traditional Best in Class or ‘Leaders’ index selects the most highly rated companies.

Excluded companies account for around 7% of the benchmark, meaning investors using MSCIs most simple ‘Screened’ index (MSCI World) still have exposure to 93% of the market. It results in a small tracking error of around 0.5% yet has a significant impact on channelling money to more ESG-minded companies in line with the respective ESG exclusion criteria. “Despite a small tracking error this index gives a considerable reduction in exposure to carbon intensive companies at the same time as improving exposure to companies offering climate solutions. It tells us ESG ‘Screened’ is a small step for you as an investor, but it’s a significant step for society,” says Giese.


“ESG is a good air bag in your portfolio during a crisis,”

Guido Giese, Executive Director, Core Equity Research, MSCI


He also shared with attendees that ESG indexes have performed better during COVID-19. Critics have argued that ESG’s outperformance during the pandemic is linked to large inflows, whilst others have said that ESG has done no better than traditional style factor exposures like low volatility. “We looked at the P/E ratio of the ESG index versus the benchmark P/E and found it was fairly close. I cannot see a trend that ESG is running into a pricing bubble,” he says. Elsewhere, factor analysis shows ESG does correlate with quality and low volatility factors, but when these factors are stripped out, ESG investment still outperforms. “ESG performance was positive in every index in every region. ESG is a good air bag in your portfolio during a crisis,” he says.


Polling Question 2
Should coal mining, coal power generation be screened out of Universal Indexes?


Of course, derivative take-up faces hurdles, however liquidity wasn’t cited in a third webinar poll as a key reason why investors are staying on the sidelines – but rather other priorities, missing regulatory pressure and costs. Encouragingly, 20% of respondents said they are looking to start investing in ESG derivatives soon.

And Heyde is confident liquidity is further improving. “We are working on this with our liquidity providers and it is going well,” she says. “There is always a hidden liquidity behind the bid-ask spreads. If you approach market makers, they provide tighter spreads than what you can see on the screens. It is improving, it is just taking time.”

Polling: 20% of respondents said they are looking to start investing in ESG derivatives soon. 

She is also encouraged by the fact liquidity didn’t suffer during the worst months of the pandemic. Visible in the fact Eurex participants rolled their March-20 positions in the Pan-European ESG-X index future introduced in February 2019 to the June expiry. There was around €3bn notional traded in that month, a record month for our ESG derivatives. Even in a crisis, these products show a good performance.”


Derivatives as a tool for ESG risk management

She is also convinced that listed futures are an increasingly important part of asset managers’ value chain and infrastructure: the more assets flow into funds and structured products linked to ESG, the more trades will appear in the futures.

Pricing will also become more competitive. Bid ask spreads compete with the benchmark, and using derivatives is already cheaper than using a basket of underlying stocks. “The backoffice cost could be reduced using derivatives,” she says. “Managing in and out flows in cash via adjustments to a basket solution on daily basis could become relatively costly.”

Lastly, the experts said that EU regulation driving ESG investment, like new rules pushing Paris-aligned benchmarks, will also drive investment. “Asset managers looking for indexes that reflect the Paris-aligned benchmarks will mean people need hedging implements and futures,” concludes Giese.

Polling Question 3
What is preventing you from using ESG Derivatives?

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