HSBC has teamed up with MSCI to develop World Select SRI and Europe Select SRI Indices, which will be used by the UK bank to build a new range of structured products.

The new MSCI Select SRI indices are a response to increasing institutional demand for ethically sustainable financial investment benchmarks that were designed to deliver on three facets of ESG investment: enhanced values-based screening, reduced carbon footprint, and increased exposure to companies exhibiting positive sustainable behaviour.

The indices have been developed in response to a specific request from an undisclosed large German pension fund, according to Aveesh Acharya (pictured), director, structured equity derivatives at HSBC. "

MSCI is widely acknowledged by our clients as one of the leaders in ESG research and in addition to that is one of the biggest players in the index space as well," said Acharya. "From that perspective MSCI is a one stop shop for ESG index solutions but it also matches HSBC's DNA in the sense that we're both large well-recognised global players. The partnership is aimed at leveraging the strengths of both firms to develop a comprehensive ESG offering."

HSBC already works with a number of index providers on other index-linked product initiatives and ESG, but this development shows that there is increasing demand from clients "to incorporate more ESG in their investments on top of the existing exposure to MSCI indices", according to Acharya.

"Pension funds and other institutional investor are increasing their allocations to ESG which has become a huge theme over the last couple of years and is here to stay," said Acharya. "Few themes that have come and gone in recent years have been backed by the kind of governmental and regulatory focus that we have seen around ESG investing. You have the UN talking about it, two years ago we had the Paris COP agreement where it was agreed that carbon emissions would be a core focus for governments and corporations. ESG has become a recurring theme and every year investors are reminded about the importance of this. Moreover, some countries have passed new regulation for asset managers to report climate risk."

Acharya notes that investors are driving much of the new demand for ESG products, although there is a clear push from governments and regulators, as well as asset owners pressing their asset managers to incorporate ESG into their mandate. "one of the drivers of this activity around ESG is that the desire to manage long term equity investment risk held by institutional investors and asset managers has increased and ESG can be an effective way to reduce such tail-risk," said Acharya. "Over the last few years we have seen a number of high profile events that have brought each aspect of E, S, and G into the minds of not only institutional investors but also retail investors: oil spills as an example of Environmental risk, extensive coverage of child labor issues around the supply chain in mobile phone manufacturing highlights the social perspective. On the governance side, recent emissions scandals are another good example."

Brought together, institutional and retail investors understand that these are issues that can impact the long term risk of investments and that there is a need to manage that risk, according to Acharya. "This trend not only will continue, but it will also grow as awareness and adoption increases," said Acharya.

With these new indices, HSBC is seeking "to develop something slightly different from what is available in the market, which are typically focused on a single aspect of ESG or one type of implementation around sustainability which is basically screening (negative screening) on a values-based filter (removal of alcohol producers, controversial weapons manufacturers, etc.). Some indices may simply tilt a traditional benchmark weight according to an ESG score", said Acharya.

"We wanted to build an index solution that would tackle multiple facets of ESG investing in a single investment, by combining the best implementation of different types of ESG indices not only in terms of negative screening (a more stringent ethics-based filter), but as this does not addresses the Environmental aspects, we have added an additional carbon reduction filter (which reduces the overall carbon footprint of the index)," said Acharya.

The UK bank has taken a different approach to other product manufacturers by not using the proceeds to invest in projects that do good for society, according to Acharya. "We aim to reward good companies - an index based attempt at a sustainability technique known as impact investing," he said. "Compared to traditional impact investing where the proceeds are used to directly invest in projects that do good for society, the indirect index approach requires us to allocate more of the index's weights to those companies that are doing well in meeting the ESG requirements."

The way we have achieved this is "by running an optimisation technique that maximises the ESG score of the index with a limited tracking error against the benchmark", according to Acharya. "That way we can incorporate these multiple ESG investing aspects but with some control over the index drifting widely from a particular benchmark," said Acharya. "This enables investors to switch over from a benchmark to these ESG investments while controlling additional tracking error risk."

According to Acharya, the result is an index that performs closely to the original benchmark, but in addition to that it provides increased exposure to ESG leaders, best in class stocks (22% v 70.8%)... carbon footprint (35% reduction).

"The results show that it is effective in its goal of increasing the overall ESG score," said Acharya.

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