FTSE Russell Convenes | Episode 4, Season 3

The role of indices in today’s capital markets

August 24, 2023

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The role of indices in the markets shifted drastically during the pandemic as people’s views towards ESG changed. In 2023, how has their role changed? Arne Staal, Group Head of Product and Research at FTSE Russell, answers this pressing question and delves into current investing trends including the resurgence of fixed income. Arne also discusses if disclosure has improved since his last conversation with Jamie, his own thoughts on the current market outlook and how FTSE Russell’s product innovation process works.

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- In ESG space,it tends to be exclusion indices, for example.Different people have very different viewson what companies you should not include in the ESG index.So questions about this,is nuclear energy green or is it not green?(bright music)- Arne, thank you very muchfor coming back and chatting with us again.It's always great to see you.- Thanks for having me again, Jamie.- And now Arne, last time we were talking about the roleof indices and markets and how important they are.I want to get a bit of an update from youabout how you feel even today,the role of indices in markets.Back then, ESG was such an important topic.The pandemic changed so much,including a lot of people's views on ESG,but, you know, it drew a lot of capital into that sector.And here we are in 2023,I wondered if you could give us a bit of updateabout how you see indices in the world todayand the role they play.- Great question, and there's really two questions there.So I'll start with the big one.Role of indices in capital markets has only increased.The size of passive asset keeps increasing.That's both true in the equity marketwhere there was always a huge trendtowards index tracks investing, so passive investing.But what has happenedover the past year specifically as well,is that fixed income has come back in a big way.Inflation up, interest rates up,central bank policy changing,fixed income assets really interesting again,that's the next big wave of passive investing,So, large part in equities alreadythen fixed income growing.Well, we'll see a lot of growth so-- And you're seeing that demand from clientsin terms of new indices or product innovation?- Absolutely.I mean, there's always demand for product innovation.But fixed income is quite frankly got overlookedfor quite a long time.If you get 1/2% interest on a simple index,that's not interestingif the equity market is delivering 10% per year.- Of course.- Which is what some of the indices didbefore the monetary policy started changing again.So, role of indices, undiminished, only growingin the importance in capital markets.Then on the ESG topic, that has changed a lot.So, ESG has always been immature in that the demandfrom different investors within a region,but especially between regions, was quite different.Different considerations for climateversus governance issues, for example.And that has accelerated, that's increasingly true.And that combined with a more focused regulatory effortto understand what ESG is, what it could be,what it should be, how you need to regulate it.There's a lot of questionsabout what data sources are being used.Is it clear enough?Is it transparent enough?Is your investment objective clear?Do we actually have the data?So are companies actually disclosing the datathat's needed to make assessments in the same way?So, that is changing.Doesn't mean less demand, just means that it's maturing,but we are at that inflection pointwhere there's no clear, "This is the way forward," yet.- When we spoke last time, specifically on the topic of ESG,I know FTSE and other indices companies were tryingto come up with formal benchmarksto get certain requirements that, you know,which companies would be allowed into theseand which wouldn't be.Has the disclosure got significantly betterfrom corporates to allow you to make easier decisions?That's part one of the question.And part two is, do you actually workwith countries and governments to talk with themabout what kind of factors need to be considered?- Disclosure is getting better,but what is missing is clear frameworks, standards,regulations that really drivean even playing field of disclosure.So disclosure is getting better all the timebut it's a stop startand it's very much individual companies also gettingup to speed and understanding this is importantand wanting to be part of that.It is not, for example, accounting data, which is usedin quantitative vastly very heavily has evolvedin factor investing or factor indices,where everybody is basically usingthe same accounting standards that doesn't exist yet there.Which points to the second part of your question,do we engage with countries?Do we engage with regulators?Do we engage with rule making stakeholders?Absolutely. - Yeah.- Very actively, so we engage with the UK regulators,with the American regulators, with Asian regulators.We engage with standard status organizationsthat might be formed, for example,by asset owners to drive standards.So heavily involved in that, yes.We continuously provide feedback but also are the voiceof our clients in this is how it really should workfrom an index perspective.- You mentioned passive versus active investing just nowand there was a huge rise in inflowsinto passive investing from 2010to just before the pandemic.- Yeah. - And as you said,it looks to continue what it seems to methat a lot of it was driven by just very low rates,huge amounts of liquidity,bringing correlations close to one,that obviously, you know,you wouldn't wanna pay active manager feeswhen you could get great returnsin terms of passive investing.As we look out,there are a number of macro headwinds that we face.Where's inflation gonna be?Tensions with China, the labor market, possible recession.Do you feel that there may be a flip backto slightly towards active investing,or do you still feel like passive investingwill continue to grow?- Yeah, I love that question and full disclaimer,I invest in active funds myself.- Oh, you do? Okay.- But the evidence, the empirical evidence history showsthat active managers on average do not outperform.And every time there's change in the marketand there's volatility in the marketit gets used as a...This time is going to be different.There's change, you need an active view,you need to be very consciousabout how you pick your stocks,how you position across asset classes.So far, the evidence suggests that that's not true.On average, almost by definitionbecause most indices are in the market.So to do better than the market,somebody else has to do less well than the market.So it all evens out over time.But I do invest in some active managers, for example,because they have a impact investing mandate.They consciously invest in climate technology, for example.- In terms of product innovation,which happens at FTSE Russell,let's say you had a client who came to youand said they wanted to create an indexwhich is really focused on AI.- Yeah. - Or on big tech.- Yeah. - How did the conversations gowith you internally about how to create a product like that?- The product innovation process generally is one of...Either we see a strategic gap and we try to fill itand we'll engage with the marketand all that. - So that wouldn't comefrom a client? - Exactly.- Okay. - Yeah. Yeah.But we might get interest just by going out thereand having the discussionsand that way, you might get that dialogue going.But the other route is,there's a client that has a very specific demand,a specific idea.In the ESG space,it tends to be exclusion indices, for example.Different people have very different viewson what companies you should not include in the ESG index.So questions about this,is nuclear energy green or is it not green?- Right. - Those types of questions,you could validly argue both waysand different people will take different views.So there, we will just work with themto capture their requirementsbut also advise on what works, what doesn't work.It's very easy to come up with indicesthat don't quite work 'cause there's no liquidity in themor the turnover is strange.- So speaking about liquidity and apologies,I was an equity guy when I was a fund manager myself,but I could understandhow these big equity indices are very, very liquid.You know, the shares are tradingin their millions every day.But when it comes to some of these fixed income products,quite often they're over the counter.They may trade by appointments.How do you find out what the real price is?How does price discovery work?- So that question of liquidity essentiallyis a really good one.You can index less liquid asset classesbut you will run into the issue of,that the price you capture is the price that people seebut might not be the price they can actually trade onat any given moment.So, that's just inherent to the asset class.So is the price the price essentially?Sometimes no, but that goes with the asset class,and whether you are active or passiveor indexed or not indexed, that's just the case.If you have a particular bondthat trades one every two years,you're going to find outwhat the price is once every two years.- Right, so actually,that's how indices is helping the credit market by,it's actually creating price discovery wherepreviously, there hadn't been that price discovery.- Fixed income is very complex and nuanced.There are all kinds of different pockets of itthat work different than other parts of it.But the evidence certainly suggests that the liquidityin fixed income ETFs drives price discoveryin the underlying bonds as well.- Interesting. Yeah.- 'Cause it drives a lot of flow in those bondsand that just gives better transparency, better visibility.- I wanted to ask you about developed marketsversus emerging markets. - Mm-hmm.- The US has been such an incredible performer.I'm thinking about stocks now.I'm sure there's a lot of fund managers out there lookingfor where opportunities may lie.Are you seeing an increase in interestin emerging market indices?- Emerging market indices, not so much.- Okay. - I think that goalswith emerging market indices are inherently riskierthan developed market indices, certainly inequities.And we are in quite uncertain times.So I think investors really look for that,that there's clear evidence that something is happeningthat will support the emerging markets.And as far as I can tell, we're not there yet.So there's always interested in pockets,there's always interested in...There's a certain constituentthat looks for China access, for example,or other Asian countries are sometimes very popular.So it happens based on specific viewsbut a whole now is the time to getinto emerging markets and we see that in demand.- Yeah. - We don't have that yet.- So Arne, kind of either a professionalor a personal question, you can answer either way.Is AI something you're excited aboutor is it something you're nervous about?- First and foremost, excited.I think there's a lot of potential that comes with it.There's a lot of potential to make a lot of things easier,more productive, more efficient, data interrogation,conversations about everyday topicsthat are very well understood.Learning, I think there's a huge potential for having kids,children engaged in different waysto gradually build up their knowledgein a way that you probably can train in AI to help you with.A little bit nervous as wellin the sense that jobs will changeand who knows how much they will change.That's not clear yet, but I'm not at all concernedabout the scenario of a rogue AIthat will take offense to the human race.- No, we're not being taken over by the machinesjust yet? - No.- Final question then, Arne, as you look out,there are a lot of macro headwinds, a lot of reasonsto be cautious. - Yep.- But are you personally relatively bullish on marketsor do you think now's the timeto be cautiously more cautious?- I think there's a lot of uncertaintybut there's also very interesting things happening.Money market funds, so pretty closeto entirely safe cash like investments, right?- Mm-hmm. - Some risk in there,but it's negligible really.They're paying 4 1/2%, 5%.We haven't seen that in a very, very long time.So if you thinkthat the traditional equity premium is probably notthat much more than 4 1/2%,5 1/2%, - Yeah.- Somewhere in that range.You can get that from entirely safe investments now.- Yeah. - I thinkwhat is a bit of a shock isthat we're used to equity markets doing double digits-- Yeah. - For a decade in a row.And, yes, that probably was never going to continue anyway.- Yeah. Arne, it's always so great chatting with you.Thank you for stopping by and as ever, thanks so much.- Thank you, Jamie.Very much enjoyed it.(bright music)

Video recorded on June 05, 2023 at FTSE World Investment Forum

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