Asset Management

ETFs Driving Custom Benchmarking Boom

Jackie Bennion Deputy Editor July 27, 2021


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 customized 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-fueled 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 basket of 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 that the highly specialized work means that they have to recruit 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. They are part of roughly 3 million indexes globally, according to the Index Industry Association, which tracks the market.

"Every firm continuously evaluates their indexes to see if they are redundant, which helps keep costs down for their clients. Ultimately, our members are focused on providing the quality of indexes investors demand and not necessarily the quantity," CEO of IIA Rick Redding said.

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

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

“There is no predetermined way of doing it,” Sharma explains. “Other index providers try to 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 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 approach.

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 thematics and the army of specialized indexers it has spawned has arguably become 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.

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