What is an index?
An index is a way to measure the performance of an entire market or a clearly defined segment of the market. By investing in an exchange-traded fund (ETF) replicating an index, an investor is buying an exposure to a market opportunity that, in theory, can be predetermined using a set of rules or a formula. These formulas are typically based on market capitalisation but can also be specified by country, style factor or sector/industry classification.
So, what’s the issue?
Very simply, we see it as inconceivable that an investor can predetermine a range of securities that fit neatly into a theme that is constantly evolving. We believe the evolutionary nature of each theme is the exact alpha opportunity that presents itself to active managers.
To evaluate this claim, let’s take, for example, the rise of electric vehicles.
Electric vehicles (EVs) have been in existence for over 100 years; but it has only really been since the introduction of the General Motors EV1 and the Toyota Prius hybrid in the 1990s that the world started to actually consider using electric motors for mainstream automobiles. Jumping forward to today, electric cars have gone from the fringes of society to being seen as the cars of the future.
However, to be the future, EVs — and thereby the theme’s underlying opportunity set — still have significant room for development. Charging and electricity storage technology must continue to progress; costs, power and distance need to be competitive with internal combustion engines; and the issue of battery recycling needs to be addressed.
Importantly, it’s not just the existing car manufacturers that will help to settle these matters and drive long-term opportunities for the EV theme. Battery makers, sensor manufacturers, rare mineral miners and many other EV suppliers and industry players will all play critical roles. As the existing challenges presented by electric vehicles get resolved, new issues will emerge, and the opportunity set will change.
The technology is developing, the theme is evolving and so too must an investor’s thematic exposures. In our view, that’s what gives a theme its alpha potential. With such variables in play, how is it possible for an ETF to predetermine the market of a theme that will continue to evolve well into the future?