Can ESG equity indices be replicated synthetically?

ESG indices have become a go-to option for pension schemes aiming to align their investments with ESG objectives, particularly in addressing climate-related risks and opportunities.

Examples of ESG objectives include:

• To decarbonise portfolios
• To help insulate against potential long-term risks associated with the transition to a low-carbon economy
• To remove exposure to firms that conflict with investor values while allocating more capital to firms that better align with their ESG beliefs

Potential benefits of synthetic exposure

Synthetic exposure, using tools like equity index futures or total return swaps, offers several advantages:

Capital efficiency: Synthetic equities require only a small proportion of the capital compared to physical equities, making them a highly capital-efficient way to gain equity exposure. Additionally, replacing physical equity exposure with synthetic exposure can be a way to release cash for a scheme

Diversification of leverage: Synthetic exposure may help diversify a DB scheme’s sources of leverage. The majority of pension schemes use leverage within their LDI portfolios. By diversifying their sources of leverage across LDI and equities, managed holistically from a single collateral pool, this can increase the stability of their collateral and increase collateral efficiency

Considerations for synthetic ESG indices 

When considering ESG synthetic replication, several factors need to be considered:

Market liquidity: Liquidity for synthetic ESG instruments has continued to improve, particularly around flagship climate indices. MSCI indices continue to lead in terms of availability and trading activity, with banks most frequently offering exposure to these benchmarks. Liquidity tends to be focused on the developed markets segment of ESG indices rather than emerging markets (EM). Transaction costs for developed world ESG MSCI indices are typically close to those of the standard MSCI World index, while costs would be noticeably higher for EM ESG indices relative to the standard MSCI EM index.

Tax implications: Synthetic exposure may, for some ‘non-qualified’ indices¹, be subject to US withholding tax linked to the US regulation 871(m). Segregated mandates for UK DB schemes benefit from a 0% tax rate in any case² (as at the time of writing), however Irish-domiciled QIAIFs currently face a 15% US withholding tax on dividends, making the qualified status of the target ESG index an important consideration for this fund vehicle.

Voting rights and ownership: Synthetic ESG index exposure does not provide direct ownership of underlying shares and therefore offers no voting rights.  ESG alignment may be supported through the fact that counterparty banks typically hedge exposure by holding the underlying physical stocks – so capital continues to flow to ESG-aligned companies, albeit indirectly. For investors with ESG objectives, an index that applies exclusions can direct capital in accordance with these preferences.

Replicating physical equity strategies with synthetic exposure 

Synthetic ESG index exposure can be a valuable tool for investors aiming to align with their physical equity strategies while optimising for capital efficiency. The choice to use synthetic replication is typically driven by factors such as capital efficiency and diversification of leverage rather than a desire to alter the underlying equity exposure.

As a result, investors often seek to replicate their physical exposures as closely as possible, ensuring consistency in ESG alignment while benefiting from the structural advantages of synthetic instruments.

The future of synthetic ESG indices

Synthetic replication of ESG equity indices through tools like equity futures and total return swaps can offer DB pension schemes greater flexibility, capital efficiency and diversification benefits. While clients forgo ownership and voting rights, they can still align capital with ESG objectives. Key considerations include the available range of ESG indices, market liquidity, and tax implications.

As the market evolves and demand for ESG exposure potentially grows, the synthetic universe may continue to expand.

 

1. If an index is classified as “871(m) qualified”, it is exempt from this US withholding tax. Qualification status is based on a number of criteria including the index being referenced by futures or options contracts on relevant exchanges.

2. Assuming any relevant tax documentations are in place. 

It should be noted that diversification is no guarantee against a loss in a declining market.