The unprecedented economic turmoil caused by the COVID-19 virus has led for calls to reshape the global economy to make it fairer and more environmentally sustainable. Campaigners are challenging governments to direct their record stimulus funds towards projects and investments that benefit broader society.
As pressure builds on businesses to improve their ESG performance, it is no surprise that the world is also seeing a corresponding boom in socially responsible investing.
Investors are stepping up their search for opportunities that align with their values. ESG is increasingly shaping the investment landscape, and a whole new ecosystem is evolving to meet changing demands.
ETFs focused on ESG are booming, while derivative solutions, such as the CME E-mini S&P 500 ESG Index Futures contract, have emerged to allow for hedging and portfolio diversification, thus giving investors the products that align with their values.
1 Research carried out by ETFGI
2 Survey carried out by Mercer
ETFs that prioritise ESG matters have surpassed $100bn (€84bn) AUM in August 2020. Furthermore, ESG ETFs and Index Mutual Funds are expected to hit $1.3trn AUM by 20301.
An increasing number of investors now know it is perfectly possible to link index management with responsible investment by choosing an ESG index-based future, index fund or ETF for the core of their portfolio. The number of European pension plans that have explicitly created and formalised ESG beliefs has increased significantly, from 19% in 2019, to 55% in 20202.
The 2020-21 outlook
Renewed focus and innovation is being driven by several factors. Firstly, ESG investment is being spurred by the transfer of wealth to a younger, more environmentally conscious generation.
On the regulatory side, there is tremendous activity at the European Union level, such as the development of climate benchmarks and a common taxonomy. Clearer guidelines and details on regulation will help build momentum for index, ETF and other derivative product development. ESG is set to be a part of the MiFID II sustainable finance measures, scheduled for early 2021.
The International Organization of Securities Commissions (IOSCO) aims to harmonise global sustainability disclosure standards to make comparing information easier for investors. Such reporting requirements will mean asset managers face greater pressure to invest in these areas and will further drive volume in ESG products.
In the equity market, exclusion from an ESG-focused benchmark might make it more difficult and more expensive to raise equity capital. Inclusion will demonstrate adherence to specific investor values and make it easier for money managers to allocate funds.
Any remaining reservations about ESG investments – performance, data and analytics, cost, and choice – seem to be in decline. ESG ETFs and ESG futures provide asset managers with strict mandates to achieve ESG compliance and provide a flexible, cost and capital efficient solution.
The ETF and futures ecosystems are inter-related and complimentary to one another: as we see ETF AUM grow, we can expect an increase in interest in futures. Futures play a key role in knitting together bank and asset manager activity.
Evolving ESG Indices to Match Investor Convictions
As ESG ideologies and thinking around ESG continue to evolve, index providers are seeking the right methodology and exclusions to ensure that their criteria enable socially conscious investors to assess companies’ ESG compliance.
For many investors, climate change is one of the most important ESG risks and investment opportunities. Increasing investor attention on fossil fuel exposures has been brought into stark focus by the Paris climate agreement, which has led an increasing number of investors to commit to divest from thermal coal companies by the end of 2020.
In response to these changing investor demands, S&P Dow Jones Indices (S&P DJI) modified the eligibility rules for the S&P 500 ESG index to exclude companies that generate 5% or more of their revenue from thermal coal.
The S&P 500 ESG index aims to offer a more sustainable variant to the broad-based S&P 500 index, with similar risk and return, while at the same time achieving a boost in S&P DJI ESG score performance.
Eligibility and inclusion in the S&P 500 ESG index are based on a robust ESG scoring system. Currently, those firms with the lowest ESG compliance, meaning those involved in tobacco, controversial weapons, with a low UNGC3 score, or in the lowest ESG ranked quartile of their sector, are excluded.
The thermal coal exclusions to the S&P 500 ESG index can be expected to drive further investor take-up. This trend of ESG indices evolving in line with clients’ needs will continue.
The addition of CME’s E-mini S&P 500 ESG Index Futures allows investors to gain exposure to the performance of the S&P 500 index, while adhering to ESG principles.
Since its introduction in November 2019, the E-mini S&P 500 ESG Index Futures contracts have surpassed $10bn of traded notional and at the start of September 2020 had accumulated over 4,350 contracts of open interest, equivalent to $650m.
Demand is being driven from asset managers and hedge funds. Clients are using the ESG future for beta exposure and for easy-access hedging purposes. They are using it in both ESG specific funds where they need more ESG-orientated solutions and in non-ESG funds, where, from a top-down perspective, an ESG future helps make the overall portfolio more ESG friendly.
3 The United Nations Global Compact is a non-binding UN agreement to encourage businesses worldwide to adopt sustainable and socially responsible policies, and to report on their implementation.
ESG futures are being used in ETFs to help cash equitise and manage dividend income, and market makers are using the product to hedge ESG ETFs with futures.
Strong ESG returns
Investors have long debated if ESG detracts from returns. In the year to May 2020, the S&P 500 ESG index provided outperformance of +2.68% to the S&P 500 index. The five-year tracking error is 0.83%, enabling clients to achieve S&P 500-like performance in an ESG-positive manner. Furthermore, correlation with MSCI ESG benchmarks is typically 99.5% or higher, so clients benchmarked to MSCI can also enjoy the liquidity benefits from the S&P 500 ESG ecosystem while still getting the performance exposure they require.
Growth in ESG investing has brought renewed focus, innovation, regulatory reporting requirements and many more opportunities. ESG futures provide a capital efficient, liquid way to allocate to this important and growing segment.
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ESG: remarkable progress, evolving indices and futures growth