The launch of S&P 500 ESG Index options marks a step forward for both ESG investing and the options market.

Well, it didn’t take long for market forces to provide investors with the tools to implement index option strategies aligned with environmental, social and governance (ESG) investing.

While options on the S&P 500 ESG Index (SPESG) are not necessarily an innovative leap forward in the index option market ecosystem, in our view this development is essential for global investors’ continued progression toward deploying capital in an ESG framework.

Market Depth

The method used by S&P Dow Jones Indices to create the underlying SPESG Index is naïve relative to active ESG investing or even other systematic ESG selection approaches. It simply excludes companies involved in tobacco, controversial weapons, or thermal coal, as well as companies with low United Nations Global Compact (UNGC) scores and those ranking in the bottom 25% of each Global Industry Classification Standard (GICS) industry group on S&P Dow Jones Indices’ ESG scores. (You can see more detail on the options and the underlying index here.)

One important advantage of this simplicity, however, is that it makes it easier to support a deep and liquid options product, enhancing the potential for broad adoption.

While the cumulative difference in performance between the SPESG and the S&P 500 Index (SPX) can be significant—since the starting point of S&P Dow Jones Indices’ historical backtests, April 2010, the SPX has outperformed SPESG by 2.1% annually—the correlation of daily returns, at 0.99, has been almost perfect. Since SPESG went live on January 18, 2019, the two indices have tracked one another almost exactly.

This close relationship allows market makers for SPESG options to hedge their exposures to these new instruments in the same way as they do for existing SPX options—using SPX futures, which already back some $5.2 trillion of notional open interest in the SPX option market. That means they can manage the risk of making this market today, whereas often it can take years to develop meaningful volumes and market depth for a new index option product.

ESG Doppelgangers

Initially, we anticipate that only the most ardent ESG investors are likely to seek to incorporate SPESG options into their investment programs, given the indirect exposure conveyed by index options. Some may even argue that ESG considerations are not relevant to option strategies, particularly if they are simply hedging portfolio exposures, as they do not directly deploy capital.

We believe these new products are yet another sign of the scope and scale of the ESG movement, however, and further affirmation that index option strategies continue to evolve toward mainstream institutional investing practices. On the margins, a liquid option on an index theoretically lowers the cost of capital for the index constituents, which would mean a lower cost of capital for the more sustainable constituents of the SPESG index. While investors need to be mindful of the potential for longer-term performance dispersion between SPESG and SPX, we see no reason why the many and various S&P 500 option strategies focused on income generation, lower volatility equity exposures and absolute returns should not each have natural SPESG “doppelgangers,” giving investors an efficient “sustainable option” for their portfolios.