In February, the first European futures contracts on three environmental, social and governance (ESG) indices – the STOXX® Europe 600 ESG-X Index, EURO STOXX 50® Low Carbon Index and STOXX® Europe Climate Impact Ex Global Compact Controversial Weapons & Tobacco Index – were listed on Eurex.
Their aim was to facilitate trading and hedging of responsible portfolios. The three underlying indices are ESG-compliant versions of well-established benchmarks, following strategies that range from standard exclusionary approaches to positive integration of ESG data. By early June 2019, open interest in the ESG futures had grown to 564 million euros.
A panel at the Innovate2Invest conference on May 21 discussed how the ESG futures came to be and whether they will play a role in the future establishment of sustainable indices as key benchmarks.
Listed ESG derivatives – a secure solution for mandates
Achim Karle, Vice President for Equity and Equity Index Sales at Eurex Exchange, said that with climate action and responsible investing gaining momentum worldwide, there was a need for listed derivatives tracking ESG strategies.
“These are benchmarks market makers are already active on, and it was easy to adopt for them,” said Karle.
Karle highlighted the benefits of having a centrally-cleared contract that is simple to trade, and three different ESG strategies that fit asset managers’ strict responsible mandates.
Bringing ESG to benchmark indices
Willem Keogh, Managing Director at STOXX and Head of ESG, Thematic and Factor Solutions, explained the design process of the ESG indices in use at Eurex. Until recently, most asset owners resorted to traditional benchmarks for their responsible portfolios, at the cost of tracking errors, he said.
In the ESG space, STOXX has “been building custom solutions that are very niche for the best part of a decade,” Keogh said during the panel. “And we wanted to bring it more towards the benchmark side.”
That a usable ESG index should be close to benchmark in terms of risk, returns and components, was one of the first messages that conversations with major investors yielded, said Keogh. A second one was that an ESG index should be simple in methodology and weighting rules. Finally, it should also rely on best-in-class data.
Applying exclusionary screens was a natural strategy as they are the most popular ESG investment criteria.
The screens chosen for the recently launched STOXX Europe 600 ESG-X Index were essentially the “greatest common denominator of exclusionary screens that fit with the responsible-investment policies of all of our clients across Europe,” said Keogh.
“What we tried to do with the STOXX Europe 600 ESG-X is to take our first step in terms of standardizing exclusion criteria.” The ESG-X strategy became a comprehensive family in May with the introduction of 42 benchmark indices that implement the same sustainable exclusions and cover an array of regions, countries and styles.
How to make ESG solutions liquid
Tobias Runkehl, Institutional Trader at IMC Trading, told the audience about their role as market makers in providing liquidity for the new futures.
He said the risk of quoting a market in products on an index like the STOXX Europe 600 ESG-X is limited due to the high correlation between the ESG index and the benchmark STOXX Europe 600, allowing for large volumes. However, market makers still have to rightly assess the price of the underlying securities to accurately reflect hedging costs leading to a slightly wider order book in the ESG-X compared to the benchmark.
“Until there is enough two-way liquidity,” said Runkehl, “our part of the value chain is to enable you to transfer your risk in and out of your portfolios, on-exchange, in these products.”
The buy-side perspective: how to trade ESG efficiently
It was down to one of the originators of the futures idea to close the round of presentations. Magnus Linder, Head of Derivatives at Swedbank Robur, recounted how an internal regulation at his company led to the creation of the ESG futures.
When SwedbankRobur in 2017 expanded a proscription on the use of non-sustainable financial products to include derivatives, it raised a problem for its fund managers, who usually kept a small share of assets invested in traditional European equity futures to handle inflows and redemptions. Holding cash instead of derivatives wasn’t an ideal option as it would lead to a performance mismatch with the benchmark.
This situation was the starting point of initial consultations and later collaborative work that involved Swedbank Robur, Eurex and STOXX, explained Linder. A few months later, the solution in the form of ESG derivatives has enabled all of Swedbank Robur’s ESG funds to be fully invested and fully ESG — something that Linder calls “quite unique.”
Linder commended how client demand resulted in a successful cooperative chain: from investors seeking sustainable funds, to the funds company then asking for the right vehicles to address the investors’ demand, to the sell-side and exchange responding to those needs.
“It is easier as buy-side today to have an opinion and have an influence” on what the next generation of exchange-listed products should be.
The ESG derivatives available at Eurex were not only a solution in terms of mandate and compliance, Linder explained. The futures result in significant savings relative to trading an ESG basket of stocks, he said. An upcoming post on this blog will elaborate on the cost advantages of trading listed derivatives.
Swedbank Robur’s move to adopt ESG principles and exploit the versatility of financial products may foreshadow a trend. Linder forecast that ESG indices could be the new benchmarks within five to ten years.
Keogh seemed to agree with this stance.
“This is the first step that we’ve taken; this is clearly not the last one,” he said. “We will keep on integrating ESG further. A base is set now and from here we can start building new and innovative solutions.”