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Beware Of Unexpected Holdings In Synthetic ESG Products

by Euro Times
October 4, 2022
in Business
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By Detlef Glow

Sustainability-oriented investors should expect to find some unexpected holdings in their portfolio when they choose products with a swap-based (synthetic) index replication approach. While index products with a full replication approach hold normally only the constituents of their respective index, the portfolio of a synthetic product is built with a swap that replicates the risk/return profile of the respective index and the so-called collateral. The securities held as collateral are often chosen based on their liquidity and transaction costs, as this helps to minimize the costs of managing the product. If the securities for the collateral are not chosen with the respective ESG criteria in mind, one may find holdings within the collateral which might not be considered as sustainable by investors and market observers.

In more detail, we found holdings such as TotalEnergies (TTE), Eni (E), Volkswagen (OTCPK:VWAGY), BMW (OTCPK:BMWYY), or HeidelbergCement (OTCPK:HLBZF) in the collaterals of synthetic ESG-related index funds.

Even as these synthetic index funds may technically fulfill the requirements to be classified under article 8 or 9 of the Sustainable Finance Disclosure Regulation (SFDR) given the nature and the economic exposure of the tracked index, the current collateral held by the products might not meet the expectations of investors since they may come from industries or sectors which are not considered sustainable by them.

That said, one needs to bear in mind that the preferences of investors define what a sustainable investment strategy is, and which assets are considered as sustainable. These personal preferences lead often to controversial discussions. Therefore, a view on the current regulation and the respective guidance given by the EU Commission may help to find out more about the eligibility of securities for a collateral.

“… Article 9 of Regulation (EU) 2019/2088 remains neutral in terms of the product design, or investing styles, investment tools, strategies or methodologies to be employed …” as the EU Commission has outlined on page 5 of its Q&A on Sustainability-Related Disclosures published on July 14, 2021, and it clarifies on the same page that: “…A financial product, in order to meet requirements in accordance with prudential, product-related sector specific rules may next to ‘sustainable investments’, also include investments for certain specific purposes such as hedging or liquidity which, in order to fit the overall financial product’s sustainable investments’ objective, have to meet minimum environmental or social safeguards, i.e. investments or techniques for specific purposes must be in line with the sustainable investment objective…”

With regard to this, it might be hard to explain holdings such as those mentioned above to investors in an ESG-related product which replicates a Paris-Aligned Benchmark (PAB) or a Climate Transition Benchmark (CTB) and is therefore classified as an article 9 product under the SFDR. Opposite to this those holdings might be fine in an article 8 product which follows a “Best-in-Class” approach.

This means that sustainability-oriented investors who want to choose a product with synthetic replication need to add an extra layer of due diligence to their product selection process. They need to review the portfolio holdings of respective products on an ongoing basis since the collateral can change over time. On the other hand, investors who chose a product which uses a full-replication approach to replicate the index would only need to perform due diligence of the index to ensure that the index methodology and the resulting index constituents meet their expectations.

More generally speaking, sustainability-oriented investors have always had to do a proper due diligence on the index and product level when they want to buy a mutual fund or ETF with a sustainable or ESG-related investment objective. This is the only way to understand which criteria are used to determine the constituents of the index. Nevertheless, synthetic products require an extra level of analysis as investors need to make sure that the holdings in the collateral are also in line with their expectations. Investors can’t make any assumptions about the ESG credentials and their outcome on a portfolio level from the product name and/or the SFDR article assignment.

The views expressed are the views of the author, not necessarily those of Refinitiv Lipper or LSEG.

Original Post

Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.



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