Innovation spotlight: ETFs and stock indices

In the final part of our series on product innovation we look at the emergence of exchange-traded funds and developments in stock indices.

Exchange-traded funds (ETFs) have established themselves as a highly cost-effective investment tool, with investors able to gain access to an entire index without the burden of investing in each of the constituent stocks. With index futures preferred for short-term trading purposes, ETFs are widely regarded as an efficient tool within portfolios.

New launches continue to hit the market every year, as the asset class grows exponentially. Around US$86 billion of net new assets flowed into equity ETFs globally in the first six months of 2014. Sylvain Thieullent, CEO electronic trading EMEA & Americas at Horizon Software, a provider of execution software for delta one products, points to Barclays’ Volatility Index ETF as an example of the wider impact of popular ETFs.

“Barclays’ decision to issue ETFs on the VIX was a massive success, with many asset managers wanting a piece of the exposure on the volatility,” he says. “Where normally the ETF is supposed to be driven by the underlying, we saw the reverse. They had to hedge so much on the futures and options under the VIX umbrella that the ETF began to drive the future and the options market as well.”

Thieullent suggests demand for index-based ETFs could further change market dynamics. “Every trader has some STOXX 50 in their portfolio. If tomorrow it becomes normal to replace these with an ETF, we could have some massive side effects,” he says.

One area of growth is the number of ETFs based on MSCI indices, including a recent ‘quality’ multi-factor range issued by State Street. In the first half of 2014 there were 75 new ETFs based on MSCI indices, representing almost one third of all equity ETFs launched during that period.

Taking stock

MSCI has been the main challenger to longer-established indices, such as S&P500, FTSE 100 and EUROSTOXX 50. As well as providing the basis for around 650 ETFs, there is now around US$7 trillion linked to MSCI indices.

Stock indices help managers facilitate in and outflows of funds, hedge existing equity exposure and enhance portfolio performance. “The market is moving away from standard indices to either more global or regional indices, and from there to more bespoke indices,” according to one senior trader.

“There is increased interest in MSCI indices by big institutional investors that are managing their overall equity exposure worldwide. This has led to an increase in swaps on the MSCI World and MSCI Emerging Markets World indices, and subsequently an increase of index futures on MSCI indices.”

MSCI has also been tailoring products to buy-side needs. Examples include the MSCI Minimum Volatility Index, which tracks stocks which have a minimum level of volatility, and the MSCI High Dividend Yield, for those interested in buying stock that just pay high dividends.

Out with the old

The increasing amount of assets benchmarked against the indices and improved tradability of index-based products via ETFs has driven the need for derivatives with MSCI as the underlying. Exchanges including as Eurex, Singapore Exchange and NYSE Liffe lead the way with MSCI listings.

“There is a need for new stock index and new indices in general,” added Thieullent. “Analysis is constantly being done by long-only players which are saying ‘we are looking to build a new index today where the return will be way better than from the S&P 500’ for example.”

In terms of future innovation, regulations could be standing in the way.

Benchmark principles issued by the International Organisation of Securities Commissions (IOSCO) introduce more scrutiny of new rules and, according to some, have acted as a brake on innovation. “If you want to draw a stopping point at what you can put in your index, the IOSCO principles are a restraint,” said a senior source.

In future, banks are more likely to work with index providers and vendors on new indices. “It’s getting to a point where we can’t create new products alone and have to partner with third parties to keep in line with regulations.”