Asset Management

ETFs Driving Custom Benchmarking Boom

Jackie Bennion Deputy Editor July 16, 2021

ETFs Driving Custom Benchmarking Boom

The range of indexes that track markets, themes and specific sectors continues to mushroom. New forms of financial engineering give wealth managers new ways to tap into a business area, and customised benchmarks are becoming more common. We examine developments in the field.

The benchmarking business is booming as asset managers look for new ways to package and measure investment products, carve markets into geographies, and create new investment themes in search of an edge.

This quant-fuelled analytical plumbing of the funds industry has been adding layers of complexity as the growth of thematic exchange traded funds (ETFs) has taken off. The size of the industry is big: assets under management in ETFs and exchange traded products stood at $9.1 trillion at the end of May (source: ETFGI).

“Building a straight market-cap-weighted broad-exposure index is not that difficult, but building a thematic index is a lot more tricky,” Rahul Sen Sharma said. The managing partner at custom-index provider Indxx, based in New York, believes that thematic indexing has reached a tipping point as investors grow more comfortable with the ETF structure, and innovation at the retail end is shaking up the rest of the market.

The firm belongs to a dozen or so smaller providers that sit below MSCI, S&P Dow Jones, and FTSE Russell as the “big three” owning the lion’s share of the ETF tracking market.

Most of its product development is done by a team of 60 indexers based in India. Sharma says the highly specialised work means recruiting from India’s top universities.

The global scope of the company, founded in 2005, which also has offices in Miami, has only taken off the last couple of years, he said. “We were really focused on the US, but the ETF story has gained a lot more acceptance globally and we have grown with it.”

Bank of America estimates that the ETF market overall will reach $50 trillion by the end of the decade.

So far Indxx has created around 90 custom benchmarks for ETF issuers that are tracking roughly $20 billion in assets.

The task of building a custom index takes anywhere from four to six weeks, Sharma said, and the work often cuts across geographies, industries, and sectors as researchers cast a wide net for useable data.

5G mobile technology is one thematic example. The first generation of 5G phones was introduced last year delivering faster speeds and latency, and boosting sectors such as the Internet of Things (IoS) which relies on network capacity for growth. Indexing the 5G-investment proposition involves looking at the entire ecosystem, from chip manufacturers and hardware and software to the telcos that put up the towers.

“There is no predetermined way of doing it,” Sharma explains. “Other index providers try and use a predetermined classification system, but in our opinion that doesn’t work."

Research has to be done on a company-by-company basis to identify what companies are active in the area and ideally generating a majority of their revenue from it, he said. The firm counts HAN, First Trust, Alps, and Global X among its ETF clients.

Wealth attractions
How much thematic benchmarking is attracting the attention of wealth managers or investment officers at family offices depends on the advisor, Sharma said.

“Some advisors are more strategic. Let’s just provide our end investors with broad-based low-cost index exposure and maybe provide some ancillary exposure to these potentially high-growth themes as a low percentage of the portfolio.

“You have other wealth managers who are more tactical, who are willing to take bets and see what is happening with the market,” he said. This was demonstrated when the firm saw a huge amount of money flow into products tracking its cloud computing indexes last year at the start of the pandemic, based on investors taking a more tactical bet.

Identifying areas of the market difficult to classify and build benchmarks around, Indxx launched a private credit index in the US last year in response to client demand.

Bespoke benchmarks are arguably at their most potent in cracking the darker corners of the private market where data has been harder to access and classify, and home to large asset classes such as private equity, infrastructure, private credit, real estate, and venture capital.

Private debt has returned roughly 8 per cent over the last 15 years; private equity higher at around 12 per cent, and performances that are becoming harder to come by.

The growth of thematic ETFs and their potential for all investors has spawned an army of specialised indexers that are arguably becoming the tail that is wagging the investment dog.

David Miller, executive director at Quilter Cheviot, recently raised the question of whether active management will deliver better returns than index tracking as the latter continues to diversify.

Alleged flaws
Given the mixed opinions about how the main global equity indices are constructed and “slavishly followed”, he points out obvious market flaws. At present, China, the second largest economy in the world, has an index weighting of only 5 per cent, compared with over 60 per cent for the US. India accounts for about 17 per cent of the total global population but only 1.3 per cent of the index, he said.

“I suspect that eventually size will matter when it comes to economic dominance,” and they will catch up, Miller said.

As for technology’s growth over the last 20 years, Miller argues that it wasn’t captured by conventional investment tools such as yield, price/earnings multiples or even profitability. “Those who took the leap into uncertainty by creating a technology sector side pocket, unaffected by index weightings and independent of their core portfolio, have been well rewarded,” he said.

That being said, assets flooding into passive index-tracked ETFs grew at an annual rate of over 20 per cent last year. Thematics grew by almost 80 per cent.

Batteries and robots
Some of the most heavily trafficked ETF themes so far this year have been in battery technology, robotics and automation, according to market watcher ETF Securities.

“Taking figures from the beginning of the year to the end of June, flows into ETFS Battery Tech and Lithium ETF accounted for more than 36 per cent of total flows over the period,” head of distribution, Kanish Chugh, said.

Healthcare, cybersecurity, data and analytics, and cleantech are examples of benchmarks that Indxx has been constructing for issuers. “US and global infrastructure indexes have also done very well for us,” Sharma said. Space is another hot theme.

With larger issuers such as iShares also launching thematic ETFs, he believes that the market has reached critical mass.

ESG interest and more self-directed investors are playing their part.

“You can look at the growth from two perspectives,” Sharma said. “First, retail investors are asking their advisors for these types of exposures. We have seen great adoption of our climate change solutions index outside of the US, not as much here in the US, so part of it is retail investor driven.

“Another part, of course, is the pension funds and institutions realising that this is an area they need to focus on from an ethical perspective.”

Regionally, the firm has seen a surge of thematic product innovation in Europe and high-growth in the Middle East. Israel in particular has shown interest. Over a billion dollars of ETF assets In Israel are tracking its products, he said. The firm also named South Korea, Japan, Taiwan, Hong Kong, Australia and Singapore as territories using its services more.

Indxx divides revenue research of companies into three buckets.

The first is for pure play companies generating 50 per cent or more of their revenues from that specific theme. “In some cases we might include what we call quasi-play companies, which are companies typically generating between 20 and 50 per cent of revenue from that theme.”

For an emerging theme, where only a few companies are represented, indexers might include marginal companies generating at least some portion of their revenue from the theme, he said.

With research typically revenue based, how does the firm account for risk; if, for example, a company is doing something questionable for its reputation that could blow up later and damage revenues?

“In some cases and some industries, typically the smaller and newer industries, we also include a monthly corporate governance review.”

The firm did this for a recently launched SPAC index.

“If there is an admission of a violation of any laws, if companies have paid fines in the past or entered into settlements, those are some examples of behaviours that have gotten them excluded,” he said.

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