FTSE Russell Traditional sector classification framework not enough to capture new trends

FTSE Russell entered the thematic segment of the structured products market in 2022 with the FTSE Developed Europe Index which was featured across 12 products sold in France worth an estimated US$66 million, which is testimony to the index provider’s renewed focus in the structured products market.

In the decrement space, FTSE Russell has seen several of its synthetic dividend indices used across 120 products worth an estimated US$300m over the last two years - its presence was limited to the UK and France which registered several of its decrement indices including the FTSE Custom 100 Synthetic 3.5% Fixed Dividend Index; FTSE 100 Equally Weighted 45 Point Decrement Index; FTSE Transatlantic EW Decrement 50 Points TR Index and FTSE France 40 Low Carbon ESG Screened Decrement 50 Points Index.

On the current driver of thematic indices, Norbert Van Veldhuizen, head of equity index product, Emea at FTSE Russell, points at “the megatrends that are changing our society and the world we live in” as well as climate change “although this is more of an investment theme in Europe than in the US”.

Other themes being developed at FTSE Russell from an index perspective include the digital economy, the Internet of Things, connectivity, cybersecurity and the future of transportation.

“People work from home, connect with work in multiple ways and don’t go to the High Street to shop but rather shop online and have goods delivered to their house,” says Van Veldhuizen.

“Online shopping isn’t new but is still a big driver of how we live our lives and is impacting various industries.”

Van Veldhuizen notes that the growth of “the big Amazons” is not only impacting real estate and high street retails but also warehouses and inner cities like London which “are pushing for cleaner air and introducing congestions charges which supports the development of electric cars and delivery vehicles”.

“Those are just a few examples of big trends in society that are recognised more and more by investors as they offer opportunity,” says Van Veldhuizen. “Thematic indices offer a way for retail investors to implement their vision and investment ideas and incorporate them in their investment portfolios. We see more demand from retail investors for thematic indices.”

The problem the market faces, according to Van Veldhuizen, is that not all these trends and themes can be captured in one sector and the traditional sector classification framework alone is not enough.

“Therefore we are using new and more agile techniques to capture the trends that are going beyond the sectors as some themes overlap and theirs is also a crossover around companies and their activities,” he says. “We are using a more flexible approach in addition to the sector classification.”

Is the structured products market offering new opportunities when it comes to innovation around thematic investing?

That’s the nature of the structured products market. In the past, ETFs were seen as an efficient vehicle to bring innovation in the form of new exposures, but the structured products market has become over time a catalyst for innovation.

Issuers are more flexible to push out products and be opportunistic. An ETF provider must go through the regulatory issuance process which can be lengthy whereas for structured products the issuance process is easier - we construct the index, and the manufacturer models the derivatives and options around the underlying and wraps it in a product.

Structured products and ETFs target the same kind of audience and they both offer flexibility to access market trends.

Some themes are difficult to classify. Are there any concerns in relation to emerging thematics and adding unnecessary complexity to underlyings?

The transparency of the methodology and the rules-based approach are elements to protect the end investor.

Retail investors are not financial experts and some themes around technology are less transparent in the sense that there is no standard for artificial intelligence, for instance, because some of these trends are emerging at a very quick pace.

There is no sector to classify artificial intelligence, and these are problems coming up on the back of emerging thematics. Standardisation will be key for the indexing industry in general to ensure thematic indices remain a simple building block for retail investor.

What are the criteria FTSE Russell’s uses to define themes that are consistent and relevant for the long haul?

It is important to define themes that are long lasting as opposed to ‘flavour of the month’ type of dynamics as we saw with 3D or wearable technology. Some companies and activities take the spotlight on the back of market developments which are not really trends.

That is why we look at megatrends and trends that are changing and impacting our society and our lives, and not as much at sub sectors and sub themes. Some themes are related to broader themes that would stand the test of time.

Do you think there is scope to grow the weight of thematic underlyings in the structured products market?

Thematic indices have a place in investors’ portfolios, and they will benefit from technology developments and improved datasets – there is increased demand for better transparent data, which has triggered the development of more specialised datasets - on climate, on carbon intensity, on ESG scores as well as other data points regarding a company’s activities and investments

I think that’s going to be broken down even further and will enable the development of robust strategies based on solid datasets that can capitalise on new techniques to get information and incorporate data points to indices beyond company reports and filings.

New techniques based on artificial intelligence (AI) and machine learning are allowing us to get information out of unstructured data and make it structured so that we can process it to build a product. Those two elements are crucial not just for the development of thematic indices but for any strategy or emerging theme.

What is your opinion on the use of overlays in thematic indices?

Overlays are a great tool for product manufacturers to manipulate the risk-return profile of an index to build attractive structured products and offer returns that are attractive to their audience.

We believe overlays offer a good way to structure products and tailor them to meet the needs of their clients in a certain market cycle. In a more risk-off and volatile environment, there’s will be more demand for defensive risk control type of overlays whereas in a different market environment there might be more appetite for risk and risk taking in which case leverage overlays can be used to implement a market conviction.

That’s a great way for investors to benefit and to protect themselves and use structured products to their full potential. As an index provider, of course, the transparency of every strategy is pivotal and regardless of the type of overlay (risk control, decrement, leverage) it should be very clear and available on the product prospectus and marketing documents.