In the second part of an interview following the partnership between HSBC and MSCI to develop a range of indices to be deployed as underlying of index-linked products, Aveesh Acharya, director, structured equity derivatives at HSBC, talks about how improved ESG reporting are taking the segment to the next level, why the focus continues to be on the 'feel good' element as opposed to performance and why ESG will complement and sit alongside equities in any future investment portfolio.

The granularity of ESG reporting is an advantage of working with MSCI which has been one of the pioneers in this segment, according to Acharya. "MSCI has a very comprehensive infrastructure not only to develop indices but also the data to report in a very granular way the impact of changing your investment," says Acharya. "These reports allow us to monitor specific exposure within the index, ESG scores, etc. This is a key point and one that not all index providers can deliver. There is always a risk when investors move over to an ESG investment and we can show what they can get by changing that benchmark."

Acharya notes that the reporting of what investors are actually achieving is also "a very important aspect" as there is a requirement for asset managers to incorporate ESG into their mandates and "this reporting can also carry over into the reporting done by product providers to end clients".

According to Acharya, performance remains a key element to drive activity. "The term 'regret risk' can be used to refer to the risk of underperformance following a switch in their traditional benchmark for alternatives, such as new ESG strategies and indices," says Acharya. "That's why we have incorporated the tracking error optimisation to address and manage this risk. Investors desire that the benchmark and the ESG index doesn't go in different directions. At the very least we want some correlation with the traditional benchmark and our methodology allows to maintain that."

However, the biggest reason why clients are investing in ESG is to avoid long term risk, according to Acharya. "We have some statistics about the use of ESG and performance is actually the third consideration when investing in ESG," says Acharya, pointing that the core reason Scandinavian pension funds which have been at the forefront of the shift towards ESG investing for the change is the addition of the social element into their mandates. "Long term risk management and the desire for societal good are the top considerations."

Performance is not necessarily the main driver activity in this segment and investors are well aware that ESG strategies can underperform in the short term, according to Acharya. "But the idea with these investments is that in the long run investors are reducing the risk of investing into companies that may face a corporate crisis and therefore the overall performance would be better than the original benchmarks which are exposed to all sorts of risks," he says. "ESG is about managing risk and that is a very important consideration for institutional and retail investors alike."

According to Acharya, the partnership with MSCI was set up with the goal of putting together a framework for index and product development. "We have developed a World and a European version, and we are hoping to apply that framework to a range of different strategies and markets/regions," says Acharya. "Specific to the retail space, we have plans to develop volatility control versions to be used as underlyings for structured products and other index products."

With the framework in place the UK bank can focus on responding to demand globally from clients and develop customised indices that would lend themselves to products aimed at the retail market, says Acharya.

"We have plans to increase our ESG offering in the retail market and this framework will facilitate that," he says. "Retail investors are growing more aware of ESG investing and there is a clear shift towards incorporating these kinds of strategies in their portfolios. Climate change and recent scandals have been pivotal in the promotion of this approach. People are also more aware of sustainability and this is also reflected in the products they want to allocate in their portfolios."

Acharya believes that there are multiple ways to look at how the different competitors differentiate themselves in the ESG segment. "The design of the indices themselves and the reporting is one element," says Acharya. "At a more generic level, partnering with MSCI gives us an edge as we have put together two strong brands with global reach. ESG is within HSBC DNA."

According to Acharya, ESG is not just talk as the HSBC employee UK pension fund has invested into ESG indices. "So we are not just selling these types of indices but also investing into them ourselves," says Acharya. "This is not just HSBC pushing a thematic investment but something we believe will deliver value to investors in the long run."

HSBC sees ESG as an overlay to equity investments in the same way as equity factors, according to Acharya. "We believe that ESG adds value to traditional equity underlyings and can be incorporated into traditional equity indices. We expect ESG to be incorporated increasingly in many investment products."

According to Acharya, if the perfect equity portfolio is exposed to the tail-risk the final performance could be compromised. "We see ESG as a methodology/technique that can be incorporated and embedded into equity investments," says Acharya. "Some of the innovation in the index space will come from combining equity indices and factors with ESG. Once the end investor starts to incorporate ESG scores in their investment decisions ESG will become a natural consideration around index and product development."

Acharya concludes that ESG investing will not compete with equities, but complement it. "It will become an essential consideration to address long term risk and align people's investments with their social views," says Acharya. "Some investor would only consider AAA rated financial assets and we think ESG ratings will become that kind of consideration in the not so distant future. Investors will only consider assets that have a minimum ESG score."

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