Index innovation nowadays isn’t as much about tracking a market as it is about developing what we’ve come to call “high-precision” outcome-focused benchmarks. In this iteration, passive investing takes cues from active management. It’s a new era for index product development. In the thematic space, for example, we’ve seen index innovation toe the line between market-like exposures and active sensibilities. This approach has opened all sorts of possibilities for product providers looking to refine and redefine market access. For investors, it’s also good news. Indexes and the ETFs that track them are getting smarter and sharper.
I had a chance this week to catch up with my colleague Jane Edmondson, head of index product strategy at VettaFi and a veteran in the indexing business. Jane is in the frontlines of index development and has a finger on the pulse of the latest trends in indexing.
We covered some big picture trends as well as specific examples of popular investment themes and how indexes are keeping up with evolving opportunities. Consider three key highlights from our conversation.
On Active Inputs Into Index Innovation
Murphy: How is an active-like mindset coloring index ideation and development today?
Edmondson: The line between passive and active indexing for thematics has always been a blurry one.
While regulators want to see objective metrics such as revenue purity tests for passive indexes, that is not always entirely feasible, especially in the case of nascent themes. Passive, rules-based indexes have to get creative with the rules sometimes to justify a name’s inclusion in an index, looking at alternative measures such as market share or third party data sources to justify qualification decisions.
For example, for some of our VettaFi indexes, we integrate clinical trial and contract information, similar to how an active manager might do so. Today, we can use inputs like natural language processing and artificial intelligence as additional inputs in the research process. All of this makes differentiating between passive and active decision making all the more difficult.
On AI: Aligning Thematic Exposures to Personal Goals
Murphy: AI has been one of the hottest themes in recent years. When we look at AI as a thematic opportunity, we see that we’ve come a long way from cybersecurity stocks to chips, software, power and robots. How do indexes go about mapping the entire supply chain and opportunity of AI, and how is access to this theme evolving?
Edmondson: It’s an interesting and complex problem. A lot of the early index implementations of AI also included other exposures like robotics. There were not enough pure-play names for AI alone.
The ROBO suite of indexes were outliers in that regard. They separated those exposures using a more active, research-driven approach to passive indexing that scored companies by thematic relevancy. This suite benchmarks products such as ROBO Global Robotics & Automation Index ETF (ROBO) and the ROBO Global Artificial Intelligence ETF (THNQ).
Today, the theme has matured. There are more pure-play implementations of AI from a naming perspective, but it’s convoluted sometimes. Do you include the picks and shovel plays on AI, like semiconductors, for example? There are active decisions being made about what exposures to include in the index.
The best approach is often what’s most desirable to the end investor. Some investors want more diversified, broader exposure to a theme and lower volatility. Meanwhile, others want a more concentrated, high conviction, pure-play only approach.
The most important consideration from an investor standpoint is to understand what you own and make sure that aligns with your investment objectives. Transparency is one of the key advantages of passive indexes.
Energy and Defense: The Role of Long-Term Views
Murphy: Energy is another theme with some complexity. It has broadened out from its traditional sector origins to a thematic opportunity tapping into the AI growth story and sustainability trends. What stands out to you as an opportunity in accessing energy as a broad theme today?
Edmondson: Energy, as a theme, constantly evolves. Nuclear energy was dead, only to be recently revived as a clean energy alternative. Electric power utilities used to be considered a stodgy income investment. Now they are the lifelines for AI infrastructure and data centers.
The important take away is that themes evolve and come in and out of favor. Investors need to maintain a long-term perspective and/or be willing to pivot as themes change and evolve over time.
Defense is another example of this. Investor perception has shifted on defense in response to heightened geopolitical risk and the trend toward defense modernization. Defense is no longer a boring industrial play. New technologies such as drone warfare, AI-software to inform battlefield decisions, and autonomous vehicles have changed the dynamics of war. Similar to nuclear energy, investor perception of defense has changed as well, with more investors becoming comfortable with the exposure. This is a much broader theme now.
Keeping Up With Benchmarks
Index innovation is ongoing as thematic opportunities evolve. For a peek at the growing lineup of VettaFi indexes, check out the Index Finder.
For more news, information, and analysis visit the Thematic Investing Content Hub.
VettaFi LLC (“VettaFi”) is the index provider for ROBO and THNQ, for which it receives an index licensing fee. However, ROBO and THNQ are not issued, sponsored, endorsed, or sold by VettaFi, and VettaFi has no obligation or liability in connection with the issuance, administration, marketing, or trading of ROBO and THNQ.
