Indices: Magic beans behind successful ETFs

Often neglected by the average investors, indices are the backbone and driver of the performance of passively managed mutual and exchange-traded funds. They are meticulously engineered to deliver strategies that appeal to different tastes or investment objectives across various sectors, regions, assets classes, or themes. In this article, we'll give you a give a quick tour of indexing and the innovative processes behind thematic indices.

What is an index?

In investing terms, an index tracks the performance of a group of assets or a basket of securities, such as a list of publicly traded companies and their stock prices. Investors use indices created by index providers as a benchmark to measure the performance of any one stock, bond, or fund against overall market performance.

According to S&P Dow Jones Indices, "an index provider is a specialized firm that is dedicated to creating and calculating market indices and licensing its intellectual capital as the basis of passive products."

Famous market indices include the S&P 500 (SPX), the Nasdaq Composite (IXIC), the Dow Jones Industrial Average (DJIA), and the MSCI ACWI - to name a few.

Indexing isn't new and dates to 1884 when the oldest stock index Dow Jones Transportation Average was first calculated and is still calculated and used to this day. The Dow Jones Industrial Average (DJIA) was created in 1896 by Charles Dow and originally consisted of 12 companies like American Cotton Oil, American Sugar, American Tobacco, Chicago Gas, Distilling & Cattle Feeding, and General Electric among others.

How indexing works today

Today, index providers can create indices that mostly cover everything that can be done with equities and fixed income over different asset classes including derivatives, commodities, currencies, interest rates, alternatives, and multi-asset indices.

The global index provider industry is highly concentrated. According to Burton-Taylor International Consulting, the three major index providers are S&P Dow Jones Indices, MSCI, and FTSE Russell. They owned over 70% of the global market share in 2020. There are other smaller providers such as Bloomberg, Morningstar, CRSP, and Solactive.

Demand for passively managed funds has skyrocketed over the past decade after years of disappointing performance at the active end — often underperforming to the broader markets. This propelled the index industry to new levels, especially in the ETF space. According to Trackinsight, passive ETF assets represent more than 95% of the total assets held in the $10 trillion ETF industry. This behemoth number led to the entry of new index providers and the launch of thousands of new indices.

The index and ETF industries are deeply intertwined. The index provider builds and maintains the index that underlies an ETF and charges a flat fee or/and index licensing fees to an ETF issuer. The ETF issuer sells the ETF shares to investors and charges management fees called expense ratios (TER, e.g., 60 basis points or 0.6%). Licensing fees are typically a percentage of the ETF's assets under management (AUM) and are generally charged when the index development process is time- and resource-consuming (e.g., Thematic or ESG).

Index engineering criteria

The Index development process is sometimes a "tough row to hoe" and can take between 1 week to 3 months to complete — depending on the client's preferences. There are different criteria involved in the index engineering process such as:

• Asset Classes: equities, fixed income, multi-asset or other (e.g. commodities).
• Strategies: Common strategies are ESG and thematic. Less popular but existing currency-hedged indices, long/short indices, volatility target/cap indices, leveraged indices, delta-hedged indices, as well as optimization indices.
• Countries & Sectors: Clients can choose to include specific markets (developed, emerging, or frontier), regions (e.g., America, EMEA, APAC, etc.), countries, or sectors (financials, energy, technology, etc.).
• Weighting: It could be market-cap weighted, a type of stock market index in which individual components of the index are included in amounts that correspond to their total market capitalization. An equal-weighted index is simple — every stock in the index has the same weight regardless of its market capitalization and thus, the same impact on the performance of the index. Finally, a fundamentally weighted index, or fundamental index, is highly customized and equity components are chosen based on criteria other than market capitalization. For instance, stocks are weighted according to factors related to their fundamentals such as earnings, dividends, and assets, commonly used when performing corporate valuations.
• Rebalancing Frequency: Several indices have constraints in terms of certain exposure to assets, countries, or sectors among others. A client can select the rebalancing frequency of the indices. It can be annual, semi-annual, quarterly, or even daily.
• Tradability: Clients can ask for suitable short- and long-term liquidity criteria.
• Cash Treatment: distribution of dividends/interests, or the reinvestment in the paying stock or across all stocks/bonds in the basket.
• Return Type: price, gross or net returns.

The rise of thematic indexing

While most indices track certain markets, sectors, and industries — the highly digitalized and technology-immersed world we live in demands new indices that capture themes, trends, and megatrends shaping our future.

Over the past few years, thematic investing has emerged alongside ESG — as one of the major investment preferences of both institutional and retail investors. In 2021, Thematic ETFs received close to $100 billion in net flows as investors flocked to get a piece of the action.

In a nutshell, thematic investing is an approach that focuses on predicted long-term trends, enabling investors to access structural, one-off shifts that can change an entire industry. Themes, however, should not be confused with sectors or industries. One can consider a sector as the 20th-century's definition, and a theme — as the mutated version of it. Themes are transcendent and reflect the interconnected and dynamic 21st-century economy. Instead of targeting specific companies or sectors, thematic indices focus on investment strategies derived from structural economic changes—such as technological breakthroughs, scientific discoveries, shifting demographics and social change, climate change, and resource scarcity. Learn more about Thematic Investing.

The process of thematic indexing

Timo Pfeiffer - Chief Markets Officer at Solactive

As demand boomed, ETF providers knocked on index engineers' doors to get their hands on creative thematic indices that cater to investors' long-term returns aspirations.  Unlike vanilla indices, thematic index design is a more complex process. To learn more, we sat down with Timo Pfeiffer, Chief Markets Officer at Solactive, to gain insights into the magic happening behind scenes. Solactive, a German provider of financial indices uses mainly a top-down approach by discovering and defining the theme. They then select companies based on their relevance to the theme before going deeper into the other fundamentals.

The process of defining the theme

According to Pfeiffer, the trickiest part of the thematic index design process is defining the theme and the investment universe. "The Solactive Global Metaverse Index” is a good example. Few people have heard about the Metaverse before Facebook's big reveal and rebrand to Meta Platforms. This is relatively a new thematic index that required extensive due diligence to capture and classify all the elements involved in the Metaverse. It takes time, expertise, and effort. Our in-house experts conduct hours of due diligence, and we would sometimes talk with outside professionals from different fields of expertise to gain theme insights. Finally, brainstormed ideas mesh together to capture an exact definition."

The selection methodology

At Solactive, there are three approaches for selecting the investment universe for thematic indices: (Sub-)Sector-based Selection, third data providers and advanced NLP algorithms.

1-   (Sub-)Sector-based selection

If the theme is easily defined, this approach is straightforward. Solactive sometimes uses FactSet's Revere Business & Industry Classification System to build the index.

2-  Third Data Providers

In some instances, Solactive collaborates with business partners or relies on external expertise like rating agencies, ESG data providers, and industry experts who already have done the homework as part of their specialization in certain niche themes.

3-  Using high-tech algorithms

The crown jewel of Solactive's indexing technologies is ARTIS®, short for Algorithmic Theme Identification System. It is the company's proprietary big data and natural language processing (NLP) algorithm. It is capable of parsing high volumes of public documents to evaluate companies’ exposure to specific themes or topics.

Pfeiffer said: "Once the theme is defined, the research team generates a set of keywords linked to the definition and then feeds them to ARTIS. ARTIS searches for those keywords in hundreds of thousands of companies' reports such as quarterly and annual filings, financial news, and business descriptions and maps companies that are related to those keywords". The algorithm then identifies a basket of companies that relates to the theme and gives each company a score that reflects its exposure to the index strategy. The set of companies is then reviewed by the team to ensure relevance to the theme of the index based on business operations. Companies that do not show adequate business exposure to the theme are removed from the selection process.

The future of indexing

While different index providers use different approaches to capture a theme, there are many similarities in the paths taken to create a final product. Increased technology adoption in the industry has made it easier to research, design, and launch new indices despite more complex client demands. The advancement of algorithms, machine learning, and AI is also helping in designing better indices and cutting costs in the long run. Consequently, ETF issuers could endure fewer costs and eventually charge investors less.

Besides Solactive's ARTIS, other key players have integrated technologies in their index creation process. For instance, the FTSE Russell’s thematic index methodology is driven by its Dynamic Classification Algorithm (the Algorithm). It uses state-of-the-art natural language processing (NLP) techniques for its new thematic range. Another key player taking advantage of algorithms is MSCI. The company identifies products, services, and concepts linked to business activities of a theme in a consistent, rules-based approach using NLP.

As the ETF universe expands and gets crowded with very similar products — index providers will continue to innovate by leveraging technologies and emerging trends. They will also be able to improve existing products by fine-tuning their sophisticated tools and eradicate the lingering problems of the corporate world — such as the investor-deceiving syndrome of "Greenwashing".

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