Index Applications

Broadly, index applications can be broken down into two main categories: the first category is designed to create passive investment products such as Exchange Traded Funds (ETFs), Unit Investment Trusts (UITs) and Options etc.; the second category is to serve as benchmarks for active asset management to track their funds or for banks to create structured notes.

ETFs are the most prevalent format amidst all kinds of passive investment products due to its low commission fee, high trading liquidity, and tax benefits etc. There is a constant capital flowing from the mutual fund into ETF space with a magnitude of trillion dollars. BlackRock projects Smart Beta ETF assets will reach $1 trillion globally by 2020, and $2.4 Trillion by 2025 on their recent press release, announcing the launching of nine new multifactor sectors ETFs, aiming to ‘democratize’ factor investing and driving innovation.  (http://www.businesswire.com/news/home/20160512006061/en/BlackRock-Projects-Smart-Beta-ETF-Assets-Reach)

UIT is also a common fund format. The Multi-National Titans Portfolio Series 1 to 9 (CMNTIX) issued by Guggenheim is a good example, according to its statement – “the Trust will invest in a portfolio of common stocks of large multinational companies that do business in multiple countries around the world. The companies selected for the portfolio derive a growing portion of their revenue from emerging market countries and may provide investors with a way to gain exposure to this potential growth without investing directly in the local foreign markets.” (https://www.guggenheiminvestments.com/uit/trust/mntp009#strategy), this UIT allows investors to get exposure to the prospering Emerging Markets (EM) stock market while avoiding the illiquidity and other regulatory constraints associated with investing in EM directly.

An example of using an index as a benchmark for fund management is the FactSet Global FinTech index (FDSFTTR), licensed to Nikko Asset Management Co., Ltd. Nikko Asset takes an aggressive, forward-looking approach, trying to capture the potential high return of companies that fuse finance and information technology. They set up the “Global – Fintech Stock Fund” in December 2016 and started operation. To monitor and track its performance, the FactSet Global FinTech Index is created. It is comprised of companies engaged in Financial Technologies, primarily in the areas of software and consulting, data and analytics, digital payment processing and transfer, and payment transaction-related hardware.  As a benchmark, this index can be licensed to other potential clients for similar purposes.

Lastly, structured investment products, also known as equity or index-linked notes, have become immensely popular among retail investors in the last ten years. (https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1342360) Large banks such as JP Morgan and, UBS always need rich types of index products for them to create better-structured notes to their retail clients. “Structured note” is an “I owe you” (IOU) type of product, usually created by large banks, to offer clients the desired exposure to general or specified investments. For example, you can have a structured note deriving its performance from the S&P 500 Price Index. Alternatively, the bank can create an exotic index blending specific EM revenue exposure and low volatility feature, based off on S&P500, and then sell to their clients this structured note. If this index goes up, the buyers get all the upside return, if it goes down, the structure note can be designed in a way that the loss is capped at the original investment capital level.   (http://www.investopedia.com/articles/bonds/10/structured-notes.asp).

Because of this flexible and derivative feature, there is a tremendous demand from banks to create such bespoke indexes. Any indexer who is able to provide this kind of indexes with low-fee and highly automated methodology will certainly get a leg up on her competitors.

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