MSCI Thematic indices create a link between the economy and the investment

Demand for thematic indexes continues to increase and now represents just under half of the client enquires MSCI receives on structured products.

Appetite for megatrends is different depending on the region. Europe is very focused on the environment, and themes like green technology and clean energy are driving the creation of new thematic indexes; whereas the US is more interested in tech and APAC sits in the middle. There is also a convergence on some megatrends like AI which are on demand in the three regions.

“Demand for thematic indexes is very strong,” says Stephane Mattatia, global head of thematic indexes and derivatives licensing at MSCI. “At a product development level, the focus is on finding themes that are part of long-term trends that are going to be relevant for six to ten years – such as green technology and demography – and not as much on short term trends that can be seen as fads, like chatGPT or the Metaverse. In this category, you want the thematic to remain relevant for the long term.”

The second leg of MSCI’s thematic indexes is driven by the global macro-economic environment and comprises indexes that are adapted to the market conditions. In this category, the index provider launched the MSCI global thematic sentiment rotation select index in late 2022 which plays on the increasing demand for thematic exposure and uses the same concept applied to factor and sector rotation strategies.

This index is aimed at investors that don’t want to be exposed only to one theme and prefer to rotate their exposure as economic conditions change,” says Mattatia. “We see a lot of appetite for this kind of strategy. The demand is linked to the return of a global macro-economic environment which was absent for 15 years, - no inflation, zero interest rates, etc. Extracting value of global macro conditions is a necessity and there a number of variables (interest rates, inflation) that you have to factor in as they are going to stay with us for a long time.”

In contrast with other index providers that see ESG as a theme, Mattatia doesn’t consider ESG as theme because everything can be looked at with an ESG lens.

“I don’t think ESG is a factor nor a theme, and it is definitely not an overlay. ESG is a super structural dimension that runs parallel to market cap,” he says.

Disclosure

Once you have established that a theme is economically sound and would remain relevant for some time, the MSCI research starts with simulations to test the strategy around the number of stocks that have been or can be captured and also applies the Average Relevance Score of the companies that are selected.

“If you go for something which is too granular with less than 10 stocks, quite often the issue is representation. You want to make sure that you have enough companies with high relevance score so that you can really capture the theme, because with some of the trends there is no pure players. If you select 20 stocks with scores no higher than 30% you are not capturing a theme,” Mattatia says.

Under the BMR as a benchmark administrator, MSCI is obliged to take extra precautions with the naming of thematic indexes and ensure they are not misleading, “especially if a theme is difficult to capture and you have to broaden the theme to have enough stocks”.

“You cannot oversell something that is impossible to capture,” Mattatia says.

Product development tools

Over the last few years, the use of different AI tools such as natural language process (NLP) to develop new thematic indexes has increased as they allow index providers to approach product development in a different way.

MSCI partnered with MKTMediaStats, a Boston-based data fintech specialised on media, to apply automatic rotation to thematic exposure using natural language process and select securities based on a specific media sentiment (MKTMediaStats Megatrend Scores).

The MSCI Global Thematic Sentiment Rotation Select Index aims to represent the performance of the four highest ranked thematic indexes, selected quarterly from a set of twenty-two MSCI thematic indexes including the MSCI ACWI IMI Ageing Society Opportunities Index, MSCI ACWI IMI Autonomous Technology & Industrial Innovation Index, and MSCI ACWI IMI Blockchain Economy Index, among other MSCI ACWI indexes.

According to Mattatia, this allows us to identify which companies are correlated with the strength of the narrative and have a point of view on how the economy is doing and offering clients real time asset, an equity allocation.

“We are working on other projects and trying to identify trends earlier and deliver performance with reduced risk. There is a huge field of activity emerging with artificial intelligence, machine learning and big data,” he says.

The market is very far from using generative AI, but there are modular parts, which have been existing for many years now in artificial intelligence, that can help create new products and identify new themes.

“AI is able to analyse millions of documents at a capacity that no human being can deliver and is allowing us to do things that the human brain could not have been able to do,” Mattatia says. “The processing of data is what makes AI an interesting tool to develop new indexes, but you still need the human element to understand every step of what AI is doing.”

Complexity, Overlays

Thematic indexes are more complex than market cap indexes and index providers must be able to justify and explain the goal of these indices in very simple terms. The use of overlays is not really related to the complexity or the lack of liquidity of thematic indices but with removing market risk and optimising the underlying to be delivered via structured products.

Some of the overlays allow trading desks to be more aggressive with pricing as they reduce accumulation on positions and the exposure an index has to dividend futures, according to Mattatia.

“This became obvious two years ago when issuers of structured products saw their trading books hit by the dividend crash. There we not enough dividend products out there to hedge the dividend exposure of indexes and decrement became the obvious way to remove the accumulation of dividend exposure on trading books,” he says.

Overlays like decrement also allow product providers to improve the optionality of the index and offer better pricing (upside) on the index.

“Having an index with lower forward allows product providers to give back this value to the investor in a structured product in the form of a higher coupon and / or a lower barrier,” says Mattatia, noting that decrement has become “a very useful tool for issuers to improve the value offered by their products. It is important however that the end investor understand that the decrement will have an impact on the performance of the underlying if it’s trending down”.

On the debate around the use of points v percentage on decrement indexes, MSCI’s preference is for decrement in percentage because the performance is closer to the benchmark, but it delivers both types.

“We have internal rules for the calibration of the level of the decrement to ensure we don’t compromise the quality and objective of the index,” says Mattatia. “Mathematically, you can apply any kind of decrement to an index, but you want to be aligned with what people have in mind.”

Fading interest?

With low interest rates the challenge for product providers was to offer meaningful coupons and upside. Higher interest rates have had a positive impact on option budgets as they allow to offer better upside and more protection. This could have an impact on the demand for indexes with overlays such as decrement. However, market data suggests otherwise. Issuers of structured products like decrement because it reduces the risk in terms of hedging but also allows them to differentiate and compete with other asset classes like fixed income that can now offer coupons of up to five percent, according to Mattatia.

“If you can deliver six to ten percent with an equity index you can fend off some of the competition coming from fixed income recently. I expect decrement will continue to be widely used for these reasons,” he says.

On the use of overlays, MSCI has started to notice some people showing signs of of ‘decrement fatigue’ whilst risk control remains an interesting overlay for structured products going forward as it enables issuers to have a dynamic leverage on the index, and a hedge that can be reinvested in the product for the benefit of the end investor.

“I wouldn’t be surprised if in the coming years we see some new innovation coming to replace or refresh the decrement overlay. I think there is also scope to see more risk control and decrement indexes alongside in the market,” says Mattatia.

Outlook

Thematic indexes are here to stay because they offer a different perspective to investors and create a link between the economy and the investment. With the increase competition coming from fixed income as a result of the rise in interest rates structured products linked to fixed income indices could be an attractive proposition.