As ESG Investment Grows, An Asset Manager Looks to Futures

Sustainability-focused funds have continued on an upward trajectory in 2020, despite a volatile first quarter.

Morningstar research reveals that 24 of 26 environmental, social and governance (ESG)-tilted index funds outperformed their closest conventional counterparts in the first three months of the year.

One in seven of these new sustainable investment funds launched in 2019 had a specific climate-oriented mandate according to Morningstar. Globally, investments in ETFs tracking ESG indices more than doubled, going from $22.1 billion in 2018 to $56.8 billion by the end of 2019, estimates S&P Dow Jones Indices.

A New Approach to Sustainability

Sustainable investment sentiment received a significant boost in January when Blackrock chief executive Larry Fink described sustainability as the firm's "new standard" for investing in his annual letter to clients.

This trend is already well established at Swedbank Robur, the oldest (and largest) fund manager in Sweden, which has been managing sustainable funds since the 1980s.

"Two years ago we updated our ethical investment policy to ensure that if there is a sustainable option for trading ETFs or futures we have to use it," explains Magnus Linder, head of derivatives at Swedbank Robur.

Enter ESG Futures

At that time, Swedbank Robur contacted all its brokers to ask them which products it could trade, but it could not find a suitable ETF or futures product. In November 2019, the firm found what it was looking for when CME Group launched E-mini S&P 500 ESG contracts. They established positions in the contract shortly after its inception.

"We wanted to include futures in our funds because leaving aside ESG considerations, funds need money for inflows and outflows," says Linder.

A fund is typically invested to around 96% with the remainder on account to cover flows, but having 4% on account means the fund may struggle to outperform its benchmark. If the manager invests that 4% in futures, it only needs to hedge the margin, leaving more than 90% of the fund's cash allocation available to manage fund inflows and outflows. Thus, including futures allows portfolios to be fully invested in the market.

"We can therefore say that all the holdings in our funds are ESG," adds Linder. "We believe an increased focus on sustainability is good for our individual fund investors as well as our institutional investors."

In the six months since launch, CME Group's E-mini S&P 500 ESG future has established itself as one of the largest ESG futures globally in terms of the notional value of open contracts, trading in excess of $5.6 billion notional since launch with an average daily trading volume of 537 contracts in 2020.

Standardization Coming

For Swedbank, ESG is one requirement when seeking a futures contract, but there are varying standards around the globe for what qualifies as an ESG fund.

Many ESG products, including futures, are exclusion-based, says Linder, meaning they exclude companies that fail to meet environmental or sustainability standards. Eventually, Swedbank hopes to see more investment products that take a proactive approach.  "We see ESG as being more about sustainability," he says.

This is a significant point. The 2018 Global Sustainable Investment Review found that negative/exclusionary screening was still the largest sustainable investment strategy globally and in Europe, although ESG integration continues to become increasingly important in the United States.

For the creation of the S&P 500 ESG Index, S&P DJI implemented a methodology that makes certain widely accepted exclusions. This includes exclusions for companies involved in controversial weapons or tobacco, and those that may not comply with the UN Global Compact.  Companies that generally have a low ESG score relative to their industry peers are also excluded.  S&P DJI is now undergoing a public consultation on potentially excluding companies deriving revenue from thermal coal.

"We saw that investors in their active investments were excluding these more," says Reid Steadman, S&P DJI's global head of ESG. "That prompted a question as to whether we should also have them excluded from the indices that lead to passive investment."

The closest thing the investment industry has to a recognized ESG standard is the Corporate Sustainability Assessment, which is run by SAM and now part of S&P Global, says Steadman. In 2019, approximately 1,200 companies completed the assessment. Further, SAM collected ESG data from public sources for another 6,000 companies. Using the data companies submitted and SAM gathered, S&P DJI created an ESG score for use in its indices.

"We feel strongly there should be latitude for the market to keep innovating and keep improving standards over time," says Steadman. "We really feel that it's the market's role to collectively come to those standards."

Waqas Samad, CEO of FTSE Russell, the index and market data provider, agrees.

"Investors are demanding much more availability of data and much more standardization around (ESG) data sets," says Samad. "I anticipate there will be a coalescing of more standards in that area."

FTSE Russell offers two ESG-focused data models currently – one that evaluates more than 4,000 companies for ESG operational risks, and another that evaluates more than 14,000 companies for "revenue exposure to products that deliver environmental solutions," according to its website.

Swedbank Robur has found that investors are demanding greater transparency around ESG funds. The firm held more than 220 meetings last year with more than 150 companies and constantly encourages the companies it engages with to be more sustainable.

Initiatives such as the GHG Protocol and the Task Force on Climate-related Financial Disclosures (TCFD) have created international frameworks for investors looking for guidance on climate-related metrics disclosure.

A Shifting Debate

Total assets under management at Swedbank Robur now stand at SEK 1530 billion (approximately $160 billion). ESG has been taken into consideration on 100% of total assets under management, and more than half (54%) of these assets have extended exclusion criteria and/or positive inclusion – a focus on companies or financial products proactively engaged in ESG products or initiatives.

Of course, sustainability alone is not enough to ensure long term demand for ESG investments. In this context, managers would have been cheered by the findings of research published by fund supermarket Interactive Investor in September 2019 showing that ESG funds outperform their non-sustainable counterparts.

For five of the six fund pairs analyzed, the funds focused on ESG outperformed over one and three years – in at least one case more than tenfold. Morningstar also found that almost three quarters (73%) of its ESG indexes have outperformed their non-ESG equivalents since their inception.

"In the past there was a debate around whether ESG factors and climate risk solutions would be drivers of performance," says Samad. "I think that's shifted now to a debate around reflecting investment beliefs of the end consumers."

Steadman says innovation in maintaining a reasonable tracking error relative to the parent benchmark has provided more confidence for those who may wish to invest in ESG.

"This gives investors comfort that they don't take just, say, one or two percent of their portfolio, but they can start putting the core part of their portfolio in investment products tracking the ESG index. They can use it in a similar way as you would use the S&P 500."

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