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Recap of the Inside ETFs Summit: Index Construction and Evolving Best Practices

12 July 2019

Last month, our Global Indices team attended the 2019 FundForum International conference in Copenhagen, which was host to more than 1500 global industry practitioners including fund buyers and asset owners, as well as asset, investment and wealth managers.

In tandem with the conference, we were pleased to participate in the Inside ETFs Summit, which kicked off the week's events. During the summit, IHS Markit's Kai Aeberli, from our Indices Research and Development team, joined a panel of experts to discuss the importance of index construction and evolving best practices.

Following is Kai's summary of the panel and key takeaways from the discussion.

Evolution of indexing, what drives the growth?

There are already many indices in the market and the index funds and ETF space has grown tremendously, particularly since the 2007/08 financial crisis. The panel agreed that this is due in part to post 2008 risk aversion and a move to a more rules-based approach for security selection.

Biggest opportunities and threats when it comes to index construction?

Some of the biggest opportunities for index construction are building strategies to allow access to market factors, particularly in the fixed-income market. Some of these are break-even inflation, alternative weighting, term premium or credit premium strategies. Additionally, indices that control exposure to themes, like green bonds and other ESG factors have also gained traction. Challenges include how ESG is defined, and whether from an issuer's perspective it should command a reduced coupon at the same level of credit risk as a "brown" bond.

How have index construction requirements evolved?

  • Traditionally indices are market value weighted. This has led to suprises in the past. For example, the panel cited U.S. shooting incidents in recent years that have created challenges for those with inadvertent exposure to gun manufacturers.
  • Indices are exposed to several factors, the effects of which on performance are not easily seperable. There is demand for creating narrower indices, which can be used as tools to provide precisely the exposure desired, and analyze sensitivity to factors during the backtest stage.

General Summary

  • In terms of innovation and growth potential, there are many indices in the marketplace today, but there is clearly an opportunity in making sure indices are constructed to reflect what they are designed to capture.
  • Profile and exposure are of key importance. The impact of market and macro events can only be analyzed by extensive and detailed research as part of the index design process.
  • Common existing strategies in the market are term premium, credit premium strategies, but there is opportunity for more filtering and clear exposure to economic indicators.
  • Investors will want to make sure the products they have invested in will react in a transparent and predictable manner, rather than having a quantum of many factors which risk offsetting each other.
  • It is foreseeable that indices exposed to one factor will become more and more common, which will enable investors to use them as tools to get the precise exposure they want without any surprises.

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