From plain vanilla to customised and bespoke

Index investing has undergone significant changes over the years.

Michael Hunstad, deputy chief investment officer of Northern Trust Asset Management and CIO of global equities, discusses the concept of index investing, trends and the outlook, in this interview with Asia Asset Management.

Which industries and sectors have been the most popular underlying areas for thematic investment in Asia Pacific in recent years? How is the development of indexes tracking popular themes such as digital assets and electric vehicles? How will these index families further evolve down the road?

In Asia Pacific, the most popular investment theme in recent years is artificial intelligence. Investors have been expecting outsize long-term potential from companies associated with disruptive technology development, such as utilisation of AI and production of processing power, especially after the technological breakthroughs in generative AI.

Another popular thematic investing segment is electric vehicles and batteries. As the global economy transitions towards environment sustainability, investors are positive regarding the industry outlook and investing in companies that benefit from increasing penetration of electric vehicles. This includes companies that produce these vehicles and components such as lithium batteries and equipment for battery production.

In response to the significant traction and growing demand for thematic investing in Asia Pacific, we have seen expeditious index development tracking the popular themes, both in terms of breadth and depth.

Index providers are launching indices covering wider themes and assets, such as digital assets. In 2021, S&P launched the Cryptocurrency Broad Digital Market Index, while FTSE launched the Single Digital Asset Indices with further plans to evolve the index family.

Index providers are also exploring different variations of indices within particular investment themes to provide specific investment exposures. For example, within the electric vehicle theme, they are publishing indices focusing on EV companies in specific regions, or in adjacent industries like EV metals or batteries producers.

Looking ahead, we expect thematic index investing to continue to grow and evolve as investors are searching for new ways to gain exposure to major trends driving future economic growth in a low-cost and simple approach, such as investing via exchange-traded funds which is underpinned by thematic indices.

Asset managers also play a pivotal role in evolving this field as they are competing to differentiate themselves from traditional index funds by providing investors with new ways to invest.

What’s the trend of index customisation in Asia Pacific? What requirements and criteria do your Asia Pacific clients usually bring up in the course of index compilation or licensing? How does the ETF market boom in individual markets like Taiwan drive demand for bespoke indexes?

Historically, the traditional model in indexing – and particularly in Asia Pacific – involved asset owners driving the choice of policy/performance benchmark, with asset managers focused primarily on implementation, i.e. beta delivery, with the sole aim of matching the chosen benchmark’s risk/reward characteristics.

A manager’s success was typically judged purely on a performance basis. But more recently in Asia Pacific, we are seeing an increase in clients seeking a more solutions-based approach from their managers, with increased guidance sought about specific products or strategies that best fit their needs.

Alongside this, we are also witnessing a shift away from vanilla indexing towards more customised, bespoke requirements incorporating exclusions at both the benchmark construction and portfolio implementation level.

From Northern Trust Asset Management’s Asia Pacific client base, over 40% of our assets under management involves some degree of customisation, including, but not limited to:

• Factor/country tilts
• Decarbonisation goals
• Environmental, social and governance thematic exclusions (weapons, fossil fuels, tobacco, etc.)
• In general, both existing and prospective clients nowadays are looking for the following solutions:
• Given the US-China geopolitical risk and idiosyncratic risk in China, there have been demands for an ex-China benchmark, and recently a China-only benchmark, in order for asset owners to dynamically manage asset allocations to China.
• Achieve optimal portfolio/benchmark reduction in weighted greenhouse gas (i.e. emissions intensity) and fossil fuel reserves within certain tracking error budget. Benchmarks are not affected if they are implemented at the portfolio level, despite higher tracking error. There are cases where clients like to incorporate that as part of their custom benchmark’s methodology in order to minimise portfolio tracking error.
• There are some readily available benchmarks like the MSCI Low-Carbon Target indices which are designed to achieve a designated level of tracking error while minimising carbon exposure through stock re-weighting. ESG screenings and decarbonisation techniques are particularly relevant among Australian and New Zealand clients.
• Mitigate index concentration by exploring equal weighted products or asset allocation advisory between large-cap and mid-cap (e.g. a mixed allocation between S&P 500 and S&P Mid Cap 400 on a US mandate to mitigate the stock concentration effect in a pure S&P 500 case). In this case, a mix of two benchmarks are used to form parent/blended benchmarks assigned to the portfolio.
• A passive solution that would achieve alignment with the 1.5 degrees Celsius of the Paris Agreement by 2050, meeting the technical requirements laid out in the EU Delegated Acts. This includes a target reduction in carbon intensity, year-on-year self-decarbonisation process, certain company exclusions, and positive tilts towards companies exposed to climate transition opportunities. Nowadays, major index providers like MSCI, FTSE, S&P and Solactive are offering Paris-Aligned Benchmark indices as part of their standard offering suite.

We are seeing growing demand for ETFs in Asia Pacific, especially in Taiwan where fundraising for high-dividend ETFs has been spectacular. Total assets in Taiwan equities high-dividend ETFs have jumped over 65% in less than six months, from NT$856.04 billion (US$26.46 billion) at the end of 2023 to NT$1,414.8 billion as of May 16, 2024, with 47% of the growth coming from newly listed products, according to data from the Taiwan Stock Exchange.

From our conversations with local pension and insurance clients in Taiwan and Hong Kong, they are now looking for income paying/steady yield strategies. This presents business opportunities for those able to offer appropriate high-dividend indices as solutions for clients.

What is the role of index investing in helping asset owners to integrate sustainability factors with their portfolios? What’s the trend in adoption of passive solutions for ESG integration among Asia Pacific investors?

While Asia Pacific asset owners are generally in the earlier stages of their sustainable investing journey, investors here are catching up quickly amid rapidly growing sustainability awareness, supportive regulations and developing industries practices.

Many asset owners in this region have already integrated ESG factors into their existing portfolios via passive solutions. As such, index investing plays an important role for them as it allows a simple, transparent and low-cost approach to sustainable investment. By tracking ESG-themed indices, asset owners can gain exposure to companies that align with their sustainable values and goals.

It’s common for Asia Pacific asset owners to begin their sustainability integration in the core equity allocation by gradually migrating from standard board market indices to a passive ESG index strategy. Popular ESG passive index solutions include:

• Negative screening that excludes investments in companies that do not meet widely accepted norms or values, such as tobacco and controversial weapons;
• Carbon reductions that tilt towards low carbon emitters based on a best-in-class or optimisation approach in order to achieve overall lower carbon metrics

It’s important to note that there are significant dispersions within the Asia Pacific region when it comes to sustainability integrations. For example, Australian investors tend to be more comfortable with sustainable investing, with more cases where they are transitioning to custom net zero framework and biodiversity solutions. But North Asia clients have been more cautious about the impact on portfolio risk and return while integrating sustainability factors.

We understand the importance of sustainable investing to our clients and continue to observe growing adoptions of passive ESG solutions. Investors now pay more attention to the different ESG strategies and customised passive solutions that best align with their unique objectives. As a leading global investment manager, we work closely with asset owners to identify the optimal solutions and deliver bespoke index solutions efficiently.

How do index providers further optimise their index methodologies and the scope of their indexes’ building blocks to better accommodate changing demand?

Given investors’ changing demand for integrating different building blocks into their mandates, index providers including MSCI are creating a wider range of indices with revised methodologies. They now have more indices with detailed and alternative metrics for designing benchmarks, including emissions of investments, climate transition scores, climate target and integrated ESG scores.

For instance, many asset owners have already, or are in the process of, switching their policy benchmark away from the MSCI World Standard to the Paris-aligned benchmark version. At the same time, vendors are aware that many large asset owners have policy and regulatory constraints and so endeavour to optimise the risk/reward characteristics to closely mirror vanilla indices.

Enhancing the methodologies of major thematic benchmarks allows external asset managers to closely track them with minimal tracking error while delivering intended reward/risk characteristics to asset owners without material deviations to their ultimate policy benchmarks.