Creating the Right Strategy at the Right Time Will Be Critical for ETF Development This Year
Two or three decades ago, passive investing was a set-it-and-forget-it exercise, but this strategy has been transformed over the last 15 years. Today, it is better characterized as rules-based investing, which removes some discretion but still allows sophisticated strategies to be implemented within an index wrapper. Investment strategies that used to be within the sole purview of institutional investors are now accessible to retail investors in a more cost-effective, transparent and liquid way.
Rules-based indexing enables portfolio managers to allocate dynamically around different asset classes or different types of investment strategies within the same investment class. Therefore, they can respond to longer-term investment trends and create a more resilient product.Pat Wolf, Head of Index Product Development at Nasdaq
Indexes that deploy new techniques and adapt to market conditions, monetary and fiscal policy, geopolitics and technological innovation are a strong foundation for product development. The goal is to capture the latest and greatest trends and the best risk adjusted returns over time.
2010 to 2021 was an uninterrupted period of prosperity in the capital markets, and riskier assets and growth-oriented investment strategies were in favor. Thematic technology indexes and funds were designed to capture the disruption caused by digitization across business models and sectors – from clean energy to cybersecurity and cloud computing. They performed well, and the trend was fit for purpose during the period of bull market returns.
A shift occurred in 2018, when central banks globally moved to normalize monetary policy. Two years later, in 2020, the global pandemic threw the world into turmoil. During 2022, interest rates and volatility increased significantly, and a recession may be looming in 2023.
“What was once old in the markets is new again in the sense that investors are looking at defensive strategies, value investing, allocations to commodities and ways to generate income over the next three to five years,” says Wolf.
An interesting theme currently is the interplay between commodities and the energy transition and the commitment to decarbonization. Technologies and infrastructure that underpin the energy transition – such as batteries, solar panels and wind turbines – will likely be in higher demand. So will raw materials that are required to build them, including lithium, cobalt, manganese, rare earth metals, nickel and silver.
While there is a well-established market for silver and nickel, the best way for investors to get exposure to the other materials is buying shares in companies engaged in mining, refining and recycling. As such, Nasdaq partnered with Canada-based Sprott Asset Management to launch a suite of indexes that provide broad and specific exposure to these materials. One is the Nasdaq Sprott Energy Transition Materials Select™ Index (METAL™), launched on January 17, 2023. A family of ETFs launched in the U.S. and Europe to track those benchmarks, and BetaShares has licensed a Nasdaq Sprott index for an ETF in Australia.
“Certain materials are important to the energy transition, and the energy transition is important to the overall demand for those materials,” notes Wolf. “We’re including materials in the index that provide exposure where there’s that two-way relationship.”
Environmental, social, governance (ESG) investing is another popular theme, but opinions on it vary. Talk to the same fund firm in two different parts of the world, and they may have different views on whether and how to implement ESG as part of an investment strategy. Usually, they have some type of responsible investment committee that determines what they can and cannot invest in.
To this end, an index’s construction and methodology needs to be transparent and compliant with certain standards or ESG labels imposed on funds by regulatory or quasi-regulatory organizations. Among them are the Sustainable Financial Disclosure Regulations (SFDR), the Autorité des Marchés Financiers (AMF) and Socially Responsible Investment (SRI) requirements in France, Febelfin in Belgium and Bundesverband Investment und Asset Management (BVI) in Germany.
Many investors want global exposures in their portfolios, but an index construction could have practical challenges in terms of fund replication. A case in point is the U.S. government’s concern about Chinese American Depository Receipts (ADRs) and lack of accounting oversight. Firms need to decide whether to remove all Chinese ADRs from portfolios in keeping with federal guidance, or perhaps buy Hong Kong-listed shares or mainland China-listed A shares to gain the exposure to those companies.
“There’s a lot of complexity that comes with managing a global portfolio,” Wolf points out. “That’s why Nasdaq builds indexes in collaboration with fund firms. We don’t want to build a hypothetical index that looks great but disregards the real-world implications of using that index as a benchmark for their fund.”
Even the most well-intentioned rules that were rigorously back tested for five or 10 years or longer may not hold up in extreme market conditions. For instance, some concentrated technology portfolios provide a pure-play exposure to a theme, and to avoid diluting it, companies on the periphery are excluded. As a result, the portfolio may be relatively small, comprising around 30 securities, some of which may be newer, smaller companies that are trying to disrupt their space.
In today’s volatile markets where interest rates are rising, future cash flows are being discounted at a higher rate, and unprofitable companies that are not returning capital to shareholders are seeing their valuations suffer. Some of these 30-stock portfolios have become 15- or 10-stock portfolios because several stocks no longer meet the minimum market capitalization thresholds set out in the index rules. To this end, indexes must be maintained in a way that is responsive to market conditions and extraordinary events. In addition, firms and investors need to understand when the strategy will likely work well and when it may not.
Although 2022 was a tough year in the capital markets, from a product development perspective, there is plenty of reason to be enthusiastic in 2023. Fund firms want to grow, and investors want new, innovative products that add value to their portfolios.
“This year is going to be challenging,” Wolf admits. “It’s not rinse and repeat like the last few years have been in terms of the types of products we’re talking about and the types of things that our clients want from us. But it’s exciting for us to adapt the work we’re doing and unearth the right ideas for the right time.”
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