Shining the spotlight on ESG in synthetic equities

Kate Jones, CFA

Investment Consultant

LCP clarity:

Synthetic equities can be beneficial for some investors but it is difficult to find good ESG options.

LCP insight:

More ESG options are becoming available. Get in touch, we can help you with finding the right solution.

My career in investment started five years ago, and in those short five years the investment landscape has changed significantly. Dare I say it… “ESG” (environmental, social and governance) used to be little more than a “buzz” word. Talking about it was one thing but genuinely integrating it into the investment process and truly believing it mattered was another. Things have dramatically changed since, and an array of investment options with very strong ESG credentials are now available. An exception to this has been synthetic equities.

So firstly, what are synthetic equities?

Synthetic equities work by gaining exposure to equity markets through derivative contracts which give you a return in line with the market index they are linked to rather than investing in the physical shares.

There are three main types of derivatives for this purpose:

1. equity futures

2. total return swap

3. option contracts

How do synthetic equities compare to traditional equities

Why would you want to replicate equity exposure synthetically?

Synthetic equities have many advantages:

Implementation: trading can be quick, which can be particularly useful when taking prompt action for example de-risking or making tactical moves ie increasing exposure when market values fall.

Efficient: frees up assets for other investments eg to boost returns, diversify the portfolio or to buy more gilts to provide extra liability hedging.

Downside protection: derivatives can be structured in a way to provide downside protection (if you think markets are going to fall) by giving up some of the upside.

Inexpensive: management fees can be competitive and there are often no or low costs associated with trading (unlike physical equities where there can be high dealing spreads).

Liquidity: Derivative markets can be just as liquid as physical equities depending on the index used.

All these advantages make a strong investment case, but as the saying goes there is no such thing as a free lunch.

There are two main drawbacks compared to investing in their physical counterparts:

1. limited choice over a reference index; and perhaps more significantly

2. in a world where strong stewardship is increasingly important, you lose your voting rights and weaken your influence by investing in derivatives rather than the owning stocks directly.

Can you invest more responsibly in synthetic equities?

You have to think a bit more creatively and find derivatives that track different equity indices with better ESG credentials. There are thousands, if not hundreds of thousands, of “ESG” indices. The bad news: we believe most indices do not take account of ESG factors in a robust and financially focused manner and many ESG derivatives have been expensive to access to date due to lack of liquidity.

Cost is an important factor to consider when choosing a reference equity index. In general, indices that have more liquid derivative instruments are cheaper to invest in (ie they have a lower “funding cost”, which is the implicit cost to trade those derivatives).

Liquidity in derivatives on ESG indices has been improving and we expect this trend to continue given general market dynamics. The cost of investing in these indices synthetically is now broadly in line with the cost of investing in passive equity funds, and so some of these indices are now sufficiently liquid to represent a genuine synthetic investment option, which is really exciting for investors.

MSCI offers the main reference indices that we currently think are investible from a liquidity perspective. These indices mainly use MSCI World as a starting point and have low tracking errors (ie aim to not deviate significantly to the MSCI World) giving you comfort that the ESG index should not materially underperform the wider market.

When looking for an robust index, we look for providers that use objective and widely available data to construct an ESG-tilted index, for example carbon emissions.

In the matrix we compare liquidity against a focus on the index either applying “tilts” to stock weights or excluding stocks completely based on an ESG criteria. This leaves us four indices on the right hand side which are now sufficiently liquid to represent a genuine synthetic investment option.

Focusing in on stewardship…

Despite losing your voting rights with the underlying companies through investing synthetically, engaging with the index providers, can be an important step. The more we engage with index providers the more passive ESG index options will improve. This could have the additional benefit of encouraging companies to think more carefully about their ESG practices so that they can be included in ESG indices, and we can really begin to enact positive change.

Real life investment options

We helped one of my clients do this early last year and solved their challenge of how to incorporate ESG factors into their synthetic equities allocation by investing in the MSCI World ESG Leaders Index. Some investment managers will set up a bespoke arrangement to enable investors to invest in synthetic equities in a responsible manner and a pooled fund has been recently launched too, which also incorporates downside protection.

This is a new and exciting area for Responsible Investment and our hope is that these solutions become common place long before my next five years are complete.