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New Horizons Beckon for ESG Index Derivatives

Investor appetite for a wider range of increasingly sophisticated ESG index derivatives is latent, according to participants at a virtual roundtable hosted by Eurex and ESG Investor.

As the volume of capital directed towards sustainability increases, institutional investors and asset managers have a natural interest in the development of ESG-related derivatives instruments that enable them to hedge investments, implement ESG investment strategies and more efficiently manage cash flows into or out of funds.

In recent years, global exchanges have started to offer a growing array of futures and options contracts, tied to ESG indexes, that enable users to synthetically meet target allocations in a more timely and cost-effective manner than could be achieved by investing directly in underlying stocks.

Based on parent indices, the first generation of ESG indices were created through application of negative or positive screening to the parent. Increasingly, best-in-class approaches are now gaining exposure to specific ESG themes.

ESG index derivatives are still a relatively new product, however. And, as with any new product, the development of the market faces challenges in gaining wider acceptance.

On 25 January, ESG Investor and derivatives exchange Eurex brought together a panel of experts to discuss the current use of ESG index derivatives by investors, the growing number and sophistication of indices themselves and the challenges the market faces in order for ESG index derivatives to achieve the acceptance and liquidity required to make them a mainstream ESG financial product.

Liquid agenda

The first topic on the agenda was liquidity of ESG index futures and what needs to happen in order to see the market grow further.

“Liquidity for our clients is key,” said Christine Heyde, Product Manager for ESG Derivatives Equity and Index Product Design at Eurex. “Volume development shows that the sustainable solutions of our benchmark derivatives have become more mainstream since launch.”

Eurex, which developed its first ESG product in 2019 and now offers 38 equity and index futures products and two fixed income products, has traded 11 million contracts. Open interest at the end of 2023 was €5.5 billion. Traded volume in 2023 grew at 5.3% to 3.2 million contracts (2.5 million in futures and 680,000 in options). A broad member base is using Eurex’s ESG index derivatives, with banks and market makers providing prices for trading on screen or via the exchange’s trade entry services.

The most liquid products are on STOXX Europe 600 ESG-X, which generates 65% of total ESG volumes traded on the exchange – and represents 8% of trading of the parent STOXX Europe 600 index.

“It’s definitely an entry product for clients looking for a liquid diversified ESG solution close the STOXX-600 index,” she said.

There is an ever-broader range of products to choose from as the market grows.

In January, Eurex expanded its equity-index linked product suite by introducing futures on Socially Responsible Investing (SRI) indices based on STOXX and MSCI parent indices, covering Europe, US, World, and Emerging Markets.

Driving demand

With investor flows continuing to build in the ESG and SRI space, and asset managers mandated to target a variety of different sustainability strategies, they are likely to drive increased demand for ESG index derivatives and, thereby, generate liquidity in those products – especially as going to the cash market brings its own liquidity challenges.

On the other hand, hedging ESG portfolio positions or taking exposure to the market using a parent index opens investors up to the basis risk between the index and the fund itself. SRI-led mandates may also impose outright restrictions on taking exposure to constituent parts of the parent.

Developing more ESG index derivative instruments will go some way to resolve that issue.

“Building exposure for ESG or SRI funds where investing in the parent index is not an option will drive demand for targeted ESG products and generate increasing levels of liquidity,” said Christoph Sost, Director for Risk Management and Performance Analysis at Hypovereinsbank.

But liquidity in some of the current set of instruments still has some way to go before reaching levels that many ESG-focused asset managers feel comfortable with. It is a challenge faced in any developing market.

“Liquidity in ESG index derivatives has improved, but we’re currently in a ‘chicken-and-egg’ situation,” said Jonas Zink, portfolio manager at Tecta Invest. “Investors are put off using ESG derivatives due to the lack of liquidity, but if they started using them, then liquidity would improve.”

And, despite the market crying out for more targeted ESG index derivatives products, adding too many of these bespoke instruments at this stage of market development could lead to liquidity fragmentation.

“As the market slowly transitions, it would make sense to concentrate liquidity in only a few indices,” said Zink. “As a portfolio manager, I would much rather have one very liquid ESG index future rather than five illiquid ones.”

Sost is comfortable with the current level of liquidity in ESG index derivatives for “everyday use” in typical market conditions. “But they are probably not yet liquid enough to cater for volatile market conditions”, he added.

“Moreover, in times of extreme volatility, any common index is suitable as a quick hedge, also for our SRI strategies,” he said. “That was the case when Russia invaded Ukraine, for example. But when markets stabilised, we encountered the limitations of the market in ESG index derivatives as we found ourselves short of exposure in some sectors, for example energy, we were not allowed to be long on the investment side due to SRI restrictions.”

Growing pains

As the market moves towards more sophisticated ESG instruments that target and tilt towards best-in-class performers, they are very much reliant on underlying data, ratings and scores.

“This reliance on ratings and scores is problematic for investors as data points are subjective,” said Zink. “Different ESG data providers could have a different position on which companies are leading the transition. And if an investor is using data from one provider and wants to hedge on an index using data from a different provider, then that creates a challenge – a mismatch between the index and what you have in the portfolio.”

This question of underlying subjectivity is another barrier to the growth of an innovative market and the wider use of ESG index derivatives. Overcoming this challenge would necessitate the purchase and analysis of multiple data sets, which is prohibitively expensive and time consuming.

There is a greater need of standardisation, panellists agreed.

Regulatory challenge

The treatment of ESG index derivatives by regulators is also a hindrance to the widescale adoption in the market. Europe’s Sustainable Finance Disclosures Regulation (SFDR), for instance, which imposes mandatory ESG disclosure obligations for asset managers and other financial markets participants, largely prefers cash-based ESG investment strategies over those using derivative products.

“The reason we currently use ESG index derivatives to a limited extent is because regulation is still evolving,” said Johann Fürstenberger, Head of Quantitative Strategies at MEAG, the asset management arm of Munich Re. “As we get more clarity on how they are considered from the perspective of mitigating the Principal Adverse Impacts (PAI) of investment decisions within the SFDR, then perhaps their use may form a greater part of our investment strategies.”

The SFDR requires financial market participants to disclose the potential negative effects to sustainability from an investment, known as a PAI statement.

As ESG index derivatives are not yet acknowledged in reporting, then derivative positions do not contribute to the PAI statement. If they were, market participants argue that this would open up the market to greater participation and improve liquidity.

An investor with a very ‘green’ portfolio could build up exposure on a more carbon-intensive part of the market (e.g. energy stocks) using derivatives, but this would not be acknowledged in the portfolio reporting metrics.

“It would make sense for derivatives to be acknowledged by the regulators,” said Zink.

Greater clarity is needed in a number of areas, panellists observed, including in relation to short positions and leveraged positions.

Discussions with regulators are ongoing, with exchanges, data providers and investors playing their part in developing common understanding on matters of best practice, standardisation, and reporting to promote the ease of use and liquidity of ESG index derivatives.

But the strongest argument is perhaps the organic growth in liquidity, and in particular the take-up of the new generation of ESG index derivatives, as investor demand continues to diversify and evolve in response to the further integration of sustainability factors into investment decisions.

To register and watch the webcast on demand, click on the link.

The practical information hub for asset owners looking to invest successfully and sustainably for the long term. As best practice evolves, we will share the news, insights and data to guide asset owners on their individual journey to ESG integration.

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