There’s a number of moving parts that must come together for a successful ETF launch. One of the most important, and often overlooked, areas in the product development space is indexing.
We recently had a chance to talk with Joseph LaCorte, CEO at S-Network Global Indexes, about his firm’s background, the role it plays in the ETF industry, as well as his insights regarding factor-based investing.
ETF Database (ETFdb): What’s your firm’s story? What role does S-Network play in the ETF industry?
Joseph LaCorte (JL): S-Network is a provider of proprietary and custom indexes, specializing in the “smart beta” and “impact investing” segments. The principals of S-Network have deep experience in indexation, and have developed, maintained, traded and managed indexes and index products for many years. Over $4 billion in AUM are linked to S-Network indexes, which serve as underlying benchmarks for about a dozen ETFs.
ETFdb: As the number of ETFs has grown rapidly over the past few years, how has the indexing industry evolved?
JL: Several recent trends have been impacting the indexing industry. First, “smart beta” indexes are rapidly gaining appeal among sophisticated investors, mainly because their transparent rules-based methodologies mitigate or eliminate certain risks, including the potential for “style drift.” Secondly, ETFs based on indexes remain one of the fastest growing corners of the investment management sector, with global inflows accelerating over the past two years. Third, pending regulatory initiatives promulgated by the International Organization of Securities Commissions (IOSCO) are imposing greater discipline on the maintenance of indexes than has previously been the case.
The combination of these three factors has accelerated the scope, growth and credibility of the indexing industry.
In particular, the “smart beta” category is a potential game-changer for the entire asset management industry. This is because “smart beta” indexes have the potential to challenge ETFs based on major benchmarks such as the S&P 500 in popularity among investors. Our ESG and Sector Dividends Dogs series of indexes are two examples of core replacement/enhancement strategies. The concept is to provide essentially the same exposures as benchmark indexes with more focus on characteristics desired by investors such as ESG or opportunities for superior yield and/or price appreciations.
ETFdb: Please explain what ESG means. What is the appeal behind considering ESG ratings? Is there any evidence that suggests that companies with higher ESG ratings deliver better returns than lower-rated ones?
JL: ESG stands for Environmental, Social and Governance. Embedded in every company’s business model are risks related to the company’s compliance with globally and regionally applicable standards for these three factors. A high ESG rating means that these risks are being addressed at the corporate level.
See ETFdb.com’s List of Socially-Responsible ETFs.
A recent study by New Amsterdam Partners, an institutional asset management firm, demonstrated that portfolios concentrated in high ESG rated companies consistently outperform portfolios comprised of with lower ESG ratings. Performance, however, is often determined by one’s definition of ESG. In essence, there are two approaches to ESG investing: one is through the use of “negative screening” and the other is through a “best practices” approach.
Negative screening simply removes companies and sectors from a portfolio based on their overall business activity, e.g. nuclear technology, weapons, or tobacco. Aggressive negative screening has been known to compromise performance. The best practices approach does not exclude companies or sectors but instead selects those with the highest levels of performance. This allows for the creation of portfolios that provide desired performance characteristics, while also embodying strong ESG characteristics.
ETFdb: Who are your indexes targeted towards? What sorts of institutions or types of investors can benefit from utilizing your benchmarks?
JL: Our indexes are targeted towards all types of investors, with emphasis on investors who demand accuracy and transparency. Certain S-Network indexes serve as the leading global benchmarks for certain corners of the global economy. Examples of this are the alternative energy, water and small-cap biotechnology indexes developed and maintained by S-Net.
In general, S-Network indexes provide users with elegant solutions to often complex investment management needs.
ETFdb: There are some critics who think that ETFs have gone too far from their initial intention of offering broad-based exposure to buy-and-hold investors. What’s your take on the innovation in the ETF industry over the last several years?
JL: There is some truth to the idea that many indexes fail to deliver on their promises. There was a time when indexation meant investing in an S&P 500 portfolio. While the various ETFs based on the S&P 500 remain valid investment products, substantial demand exists for different types of exposure. A diversified index product is often able to deliver these types of exposure with less risk than would be assumed by investing in individual stocks.
Our small cap biotech index is a clear example of this. The index invests in some 73 biotech stocks with market capitalizations ranging from $200 million to $5 billion. The companies in the index must have at least one drug in Phase II or Phase III FDA clinical trials and must have certain financial metrics that mitigate the risk of bankruptcy or unexpected dilution. This market segment is regarded by many as the most dynamic segment of the biotech industry and our index, which serves as the underlying benchmark for an ETF issued by ALPS (Ticker: SBIO), provides investors with carefully researched and well-diversified exposure to this corner of the market.
We think it does a better job for most investors than the alternative, which normally would be to try to pick a couple of stocks in the segment and hope for the best. With products like this coming to market, our view is that the ETF industry is substantially improving the opportunity set open to investors of all stripes.
The Bottom Line
Innovation in the indexing industry has gone hand in hand with the growing popularity of the exchange-traded product structure. Looking ahead, it’s clear that thoughtful index creation will remain as one of the key ingredients behind successful product launches.
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Disclosure: No positions at time of writing.