Why you should look under the hood of your thematic index

Indxx, which builds custom indexes, urges advisors to study the methodology so you know exactly what you're buying into

Why you should look under the hood of your thematic index

As the thematic index field becomes more crowded, advisors should look under the hood of their indexes and understand how a theme is built before they choose one, Rahul Sen Sharma, Managing Partner of Indxx, told Wealth Professional.

“Just because you have two indexes that are called a cloud computing index or cybersecurity index doesn’t mean they own the same companies. They can be very different,” he warned. “Our research has shown that you can have 50-60-70% divergence in terms of overlap, weights, and holdings. So, I think the number one thing is to look under the hood and make sure that it comes from an index provider that also has a history of being able to build thematic indexes.”

Indxx was one of the early pioneers in providing thematic indexes. After six years, its indexes are tied to $20 billion in assets under management (AUM).  While it builds top-quality custom indexes, it has shown the largest providers, who weren’t initially too focused on thematic indexes, that there’s good money to be made in the field, so it’s now seeing more competition.

Indxx’s indexes differ from others in three ways. First, it looks at a theme from the entire global equity space since the companies driving a theme often come from different countries.

Second, Indxx researches to understand both the theme and revenue that a company is deriving from it rather than using a predetermined classification system. It usually requires the company to derive 50% of its revenue from the theme to go into its thematic index, but Sharma said, “we can lower it if it’s a newer theme and the revenues aren’t as large at the moment.”

Building a thematic index is different than building a simple sector or market cap one since themes can cut across industries and countries, so there’s no easy way to do it. He said those who use a predetermined classification system aren’t providing the most accurate theme treatment.

“When we’re building a theme in-house, or when a client approaches us to build a thematic index, the first thing we do is try to understand where the theme came from, where it is today, and where it’s potentially going, what the drivers are, for example, in terms of the theme’s evolution, and that allows us to come up with a methodology that will target the theme most effectively.

“We use sub-themes as building blocks to target the theme overall,” said Sharma. “That’s a very important part of the process because often you’ll have two indexes, which have a very similar name and maybe sound like they’re targeting the same theme. But, when you look under the hood of the methodology, you’ll see that the way they target the theme is very different.”

Lastly, Indxx annually reviews its themes to see how they’ve evolved, then adjusts the security selection process so themes remain targeted. It also posts its methodologies on its website, so anyone can study them and understand how they’re being targeted.

“Just be aware that all indexes are not created equal, despite the name suggesting they might be,” said Sharma.