The Evolution of Indexes and Thematic Investing

Over the past decade, index strategies packaged in ETFs have attracted an increasing portion of investors’ assets and are now exceeding $5 trillion in AUM. With the blurring of the lines between active and passive investing, the unrelenting search for alpha, and the rise of alternative data and specialized datasets, we gathered some of the world’s leading index providers and ETF issuers to discuss changes and future innovations of indexing and ETFs, especially in areas of smart-beta and thematic investing.

Moderated by Jeremy Zhou, Head of Indexing at FactSet, the panel included:

• Yuan Fang, Vice President, US ETF Product Innovation, BlackRock
• Dwijen Gandhi, Senior Director & Head NYSE Indices, ICE Data Services Inc.
• Matthew Horne, Vice President, ETF Business Development, Fidelity Institutional Asset Management

Below is a summary of key insights from the panelists.

What Are the Major Thematic Trends You’re Seeing?

• The rise of alternative smart beta ETFs transparent active as well as thematic and sustainable have led and will continue to lead the way for more variety and diversity in product offerings.
• For institutional investors with a core portfolio, thematic investing is complimentary to exisiting asset allocation, like a satellite portfolio providing outside long-term return potential in addition to the core investments.
• The trend for larger institutional investors or pension funds is to access thematic investing through private equity by either choosing indices or specialized active managers.
• Another trend is rotation, investors may consider rotating from one thematic to another based on what’s going on in the market and on the economy.
• When investors think about thematic investing, they are looking for focused exposure, and that is a big driver of creating these indices. As an example, a Vegan index has been created to follow trends in society and demand from investors.
• The next stage evolution will include more risk managed, risk focused approaches depending on the market’s development.

Is the Shift Active to Passive Irreversible?

• 60% of the entire fund universe is still in active strategy, the shift towards passive is still happening but is slowing down. We will hit some equilibrium in the future, maybe 50/50 or 60% passive and the trend might just stop there.
• The percentage of ETF and indexed strategies remains quite low and there is room to grow. Active versus passive really is active versus indexed, every investment decision is an active decision but the access to the investment opportunity can be through an active managed instrument or through an indexed product.
• There are market cycles and, at times, the ability of active managers to outperform will be higher. The impact of fees is critical, passive and index typically have lower fees and that will be a trend very hard to reverse.
• The growth of smart beta as a segment of passive has grown over the last years, smart beta being a rules-based way of expressing active philosophy. In the end, the debate is not active versus passive, but active in what form.
• Active managers have a greater ability to react and pivot investments, whereas an index maybe behold into some rebalance cycle and have to wait until the next quarter to update the portfolio. This might be especially useful for higher risk theme or a specialized theme where the active manager has a special knowledge into.

Have We Reached a Peak on Indexing or Will There Be More Innovation in Index Creation?

• There is an ongoing revolution in fixed income indexing, smart beta in fixed income is only starting and there is going to be a lot more research and innovations in that area.
• On the equity side, techniques and data are developing not only on the thematic side but also on the ability to access various types of data, like ESG. As these types of data become increasingly available, it will generate new products.
• A lot of products already exist but we have not yet reached the peak. The combination possibilities amongst existing products is another factor, like the thematic on cars was about hybrid electric and is now driverless cars. As the society and brands evolve, the combinations will follow.

How Should Investors Incorporate Thematic Component into Their Investments?

• The first consideration is to identify the strategy around thematic in the portfolio and the budget allocated, and then the implementation. Investors need to define if thematic investing is part of their core strategy, or if they want small or satellite exposure.
• For institutional investors with a core portfolio, thematic is complimentary to the core asset allocation, like a satellite portfolio providing outside long-term return potential in addition to the core investments.
• The trend for larger institutional investors or pension funds is to access thematic investing through private equity, by either choosing indices or specialized active managers.
• Another trend is rotation, investors might be willing to rotate from one thematic to another based on what’s going on in the market and on the economy.

Can You Explain the Challenges of Constructing Performing Smart ETFs While Making Them Simple to Understand From a Marketing Perspective?

• Strategies like market neutral types or approaches to factor strategies have been explored in the past but abandoned because of their complexity, they were harder to sell. However, the industry is now better in translating what the index/ETF is doing for investors to help them understand the robustness of the model behind an index/ETF.
• Most methodology documents for ETFs require a CFA, it’s not easy for an investor to fully understand. Asset managers have been trying to educate the market on quantitative investing, but this is a slow process. Distilling it down to the outcome and expected achievements is where the value is: explaining the methodology relative to what the investor is looking for in the end exposure.