Having your synthetic equity cake and ESG-ing it

Up until now, synthetic equities have largely been used to create capital-efficient exposure to broad traditional market indices. But given the greater focus by pension schemes on the environmental, social and governance (ESG) credentials of their equity investments, that is changing.

The growing market for capital-efficient synthetic ESG equities has the potential to offer schemes a way to blend their ESG and capital-efficiency aims together. It might not be a winner on the Great British Bake Off, but we think that pension schemes can now have their synthetic equity cake and ESG it too.

What are the ingredients of synthetic equity?

Synthetic equity instruments, such as equity total return swaps (TRS) and futures, can provide pension schemes with exposure to equity markets without the requirement to commit the full amount of capital, as they would have to with physical equities.

Many pension schemes use these instruments to gain or maintain exposure to equity markets whilst freeing up capital to be deployed elsewhere. Additionally, they should allow schemes to diversify their sources of funding as an alternative or complement to funding in government bond contracts (for example, using gilt repurchase contracts). This can result in lower and/or more stable overall funding costs, as equity funding costs have historically decreased during periods of market stress.

Historically, synthetic equity has only really been available on broad market indices, as opposed to indices with an element of ESG. This meant schemes had to choose between ESG equities and the capital efficiency of synthetic equities.

But now, on account of recent market developments, many schemes could have both synthetic equity exposure and maintain their responsible investment goals. This will of course depend on each scheme’s preferred flavour of ESG, and may also come at a price.

Different flavours of synthetic ESG equity indices

Synthetic ESG equity can typically be accessed via equity TRS, whereby the pension scheme receives the total return on a reference equity index and pays a funding cost in exchange. As a result, strategies can be tailored to reference a scheme’s desired ESG exposure.

It is important that the chosen reference index reflects the scheme’s ESG views and beliefs. There are a number of possible indices and pricing will vary between them. Banks typically offer better pricing for popular indices, with other indices potentially incurring higher costs.

The following table illustrates some indicative pricing: it’s not exhaustive and it’s subject to change, but it gives a broad indication of some of the ESG indices available synthetically and the associated funding cost. The indices available reflect a variety of investor approaches to ESG integration. The MSCI World (non-ESG) Index is also included for comparison.

The table shows that MSCI World ESG Leaders is gradually emerging as the most popular ESG index in the sense that it (currently) maximises liquidity and minimises funding costs compared with the non-ESG MSCI index. Indeed, as the market for it has grown, pricing for the ESG index is now only marginally higher than that of its parent index.

The MSCI World ESG Leaders index uses the MSCI ESG ratings to identify companies that have demonstrated an ability to manage their ESG risks and opportunities. As can be seen from the table, however, it is far from the only ESG flavour in the window: MSCI Low Carbon has a very similar funding cost, and many other indices are available too. Each scheme should consider its own ESG objectives when deciding which index to use; where appropriate, transacting via synthetic equity could allow exposure to the index in a capital-efficient manner.

An alternative recipe

On account of the range of and variations in pricing, for some ESG approaches and indices, some schemes may find it more appropriate and cost effective to integrate ESG into their equity exposure via physical equities, and access synthetic exposure elsewhere in their portfolio.

Each index is different, reflecting each provider’s different approach to ESG integration, with some more focused on exclusion than engagement, and some the other way round. Additionally there are a number of other factors which might feed into the decision around the index (see here for our previous blog on techwashing in ESG indices) which might mean that a certain index is not to your taste. It’s important to remember that synthetic equity exposure does not carry voting powers, and this limitation of engagement may be viewed by some schemes as a disadvantage when it comes to ESG.

It is possible for schemes to obtain synthetic equity exposure that also provides the ESG integration cherry on top. In future blogs, we’ll also be looking at ESG in synthetic credit. The scheme’s desired flavour of ESG is the key consideration, according to which they can choose to eat their cake in the form (synthetic or physical) that is most economically appropriate for them.

Appendix: Performance of the MSCI World Net Total Return GBP index