Index survey part 2 - Next Generation

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Index survey part 2 - Next Generation

The use of indices as underlyings in structured products forms the most popular group of assets because of the wide choice that exists among different index types. Indices also make ideal choices in terms of hedging, risk management and transaction costs.

This article will consider three groups of “next-generation” indices, classified as Thematic, ESG (Environmental, Social and Governance) or strategy based. Part one of this survey considered the “traditional” index categories of market capitalisation, sectors and factors.

Playing the themes

Thematic indices are based on a broad group of strategies which seek to harness social, economic or investment trends. This includes emerging industries such as AI and other disruptive technology as well as climate, geography and demographic changes. Thematic indices can also be aimed at broader economic parameters such as interest rates, inflation and property. In such cases success will involve a rationale that implies asset movement that is not fully priced in by the market. They are typically based on long term supply and demand or investor behaviour.

Thematic indices are not to be confused with sector-based indices (which we covered in the first article). Sector indices tend to focus on existing industries and are typically made up of companies with large enough capitalisation to be included in a benchmark index. Sector indices reflect the current economic position, whereas thematic indices are positioned for future developments. While the established index providers have created indices in this area (for example the MSCI Disruptive Technology ESG Filtered Index) it has also attracted newer index providers with a link to the FinTech world, such as Indxx which has created Global Internet of Things, Global FinTech Thematic and Millenials Thematic indices. Other indices that have been used in structured products include the Deutsche Bank Megatrends Index and the Solactive Digital Economy Index.

Ever more important ESG

We shall now consider ESG indices. Technically they belong with the thematic indices but ESG has become such a dominant topic over the last ten years or more that these indices deserve their own category. Many factors have been a driver for this, significant investor pressure and as a result companies and funds wishing to demonstrate that they are compliant with the spirit of the movement and therefore score well on ESG metrics. Further impetus has come from global regulation, led by initiatives in the EU. In 2021, The Sustainable Finance Disclosure Regulation (SFDR) which requires companies and funds to start making mandatory disclosures came into effect. This regulation and others that will follow will have a profound effect on investment markets.

Despite regulatory steer there is currently no consensus on how to best measure ESG, with the result that there are many different scoring processes used in the market. This causes confusion and the inevitable practice of seeking to artificially boost scores (known as “greenwashing”) in a similar way to how a company could attempt accounting or asset dressing techniques to demonstrate a sounder financial position than might truly be the case. The next five years will see many more developments and this may include gravitation to a more uniform standard.

ESG has seen an explosion of associated indices because of its growing popularity. The ESG process itself can be easily translated into different layers of index rules, such as measuring ESG component scores, favouring those that improve over time (indicating better compliance) and adding in traditional metrics such as liquidity, size, geography and sector. The Stoxx Global ESG Leaders Select 50 combines ESG with large cap stocks and the Euronext Climate Orientation Priority 50 focuses on climate linked companies.

Pushing the envelope with strategy indices

The final category is that of strategy indices. These have a long track record and can be thought of as extensions or combinations of the building blocks of “factors” that we examined in the first article. Strategy indices exist on a spectrum with simple rules based concepts involving one or two factors on one end with more complex algorithms on the other. Therefore they compete with quantitative funds and actively managed ETFs.

One of the first types of strategy indices are those that seek to control volatility. Within this group are two sub-types: the minimum volatility (or variance) and the volatility target. Many major benchmark indices now have such variations offered. The minimum volatility style select stocks from within the parent index based on historic volatility calculations. In the case of low volatility they simply pick the lowest volatility stocks as measured over a previous period (the S&P-500 takes the lowest 100 by historical volatility over the previous year) and some weight inversely by volatility. Such a methodology is easy to understand and calculate, however it is possible for the low volatility version to actual have a higher volatility than the parent if the stocks chosen are highly correlated with each other. The minimum variance avoids this (at least on a backward looking basis) by selecting a combination of stocks that have the lowest portfolio volatility. The volatility target indices simply maintain a proportion in the parent index to achieve the desired risk level, with the rest typically going into cash. Volatility controlling indices are particularly popular in structured products because they lower option prices, allowing capital protected products to achieve better participation rates.

Many other types of strategy indices exist, including searching for alternative risk premia and applying asset class switching such as the Citi Dynamic Asset Selector.

In conclusion across this two part survey of indices we see that there is a rich choice available to investors and a constant innovation and mixing of themes and ideas. Many of these indices make excellent underlyings to link structured products to.

Tags: Algorithms

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