Is it time for passively managed ETFs?

Thematic product launches are experiencing a boom. There is a strong belief that a different approach to investing is needed, avoiding the traditional sectoral and geographic classifications for equities.

Passively managed ETFs seek to take advantage of long-term economic, political or social structural changes by identifying the most relevant companies driving a theme from several perspectives, regardless of their more traditional classification.

In recent years, the benefit of engineering adaptability into a portfolio has become apparent to investors. The global pandemic has accelerated some trends that thematic funds aim to link to.

However, this is challenging, as there is no standardized classification system for thematic investments. Therefore, when it comes to designing index exposures that take advantage of thematic trends, index solution providers have to start at the bottom and define the trend they intend to tap into to create a systematic index methodology that provides good exposure to that trend.

MSCI has established a framework to classify and broadly define the trends that its thematic indexes intend to track; well-diversified megatrends across different themes and sub-themes, ensuring diversification and representativeness in the coming years. Transformational technologies, environment and resources, society and lifestyle, and health and healthcare stand out among them.

This builds a clear picture of the theme. The next step is to identify aligned business activities incorporating the theme. Products, services and concepts linked to them are mapped with a consistent, rule-based approach, enhanced by natural language processing (NLP) to analyse data. Relevance scores are then derived that measure revenue exposure to the topic of the company in question.

For example, the MSCI ACWI IMI Innovation Select ESG Screened 200 index covers all four megatrends and selects companies operating in important sub-themes, such as next- generation internet, fintech, genomics, autonomous technology and industrial innovation.

The starting point is the liquidity pre-screened MSCI ACWI IMI Index on global developed market stocks across the market capitalisation spectrum, covering 99% of global listed equities, to then apply a thematic screening to ensure the selection of the most representative companies with the highest revenue share per theme, along with an ESG screening. The final index comprises up to 200 companies with market capitalization weightings tilted by relevance, ensuring an even higher level of representativeness. Lastly, a 4.5% single-stock cap, with semi-annual screening and quarterly capping resets, provides reliable diversification.

These issues have a substantial long-term impact. You don't have to look far; genomic healthcare and the rapid development of vaccines to combat Covid-19 (with great interdisciplinary collaboration) are excellent examples of genomic science's progress and commercial applicability. In addition, genomics is expected to significantly impact other vital fields, such as drug development and cell and gene therapies, to name just two important examples.

So, what’s one of the main advantages of these types of ETFs? They track indexes that offer a well-thought-out and carefully constructed rules-based methodology for thematic ETFs. They are available with very competitive fees and meet the EU Sustainable Finance Disclosure Regulation (SFDR) Article 8 standard, which is achieved without diluting the exposure to the theme.