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This article appears in the May 2021 issue of Investment ExecutiveSubscribe to the print edition, read the digital edition or read the articles online.

What’s considered to be an index fund used to be simple. Not anymore. A growing number of thematic and other specialty mandates are joining the traditional, broadly diversified, capitalization-weighted and passively managed indexes.

Other than having “index” in their name, these new strategies have little in common with old standbys such as the S&P/TSX Composite, the S&P 500 or the Dow Jones Industrial Average. They also represent an evolution beyond rules-based approaches in which stocks from a broad market universe are screened according to factors such as growth, value, momentum, quality or volatility.

Instead, specialty indexes pursue multisector investment themes or narrow segments within an industry sector. In the first three months of this year alone, newly listed ETFs in Canada provide exposure to clean energy, cloud computing, genomics, outer space and psychedelics.

Fund companies have plenty of index exotica to choose from. According to a global tally by the Index Industry Association, a trade group based in New York, there are now more than three million indexes.

“We’re well across the line that separates innovation from proliferation, to the point where there are indexes just being created for the sake of making more indexes,” said Ben Johnson, director of global ETF research for Chicago-based Morningstar Inc.

The lines have blurred between what constitutes an index and what is simply another active investment strategy. The common element in the new indexes is the existence of an index methodology. “Once that playbook’s been written, the discretion is done, effectively,” Johnson said.

Investors and their financial advisors must understand that while specialized indexes are nominally indexes, said Johnson, “there is a very significant degree of discretion that is exercised by the index manufacturer in arriving at that index methodology.”

The rollout of exotic indexes and funds that track them is seemingly limitless. “There’s always going to be room for more,” said Johnson. “For a long period of time, all things related to factors or so-called ‘smart beta’ were in the spotlight. Subsequently, ESG [environmental, social, governance] themes have come in and stolen the spotlight from factors. What captures the spotlight next is anybody’s guess.”

Driving the continuing expansion, said Johnson, is that the cost of developing the next new index is minimal — and the opportunity cost of not having the right index at the right time for a potential fund-management client is materially higher. “The incentives are to cover the waterfront and then some, with a full array of different index offerings covering all of these different kind of categories, be it factors, be it ESG, be it in themes.”

Yves Rebetez, partner with Credo Consulting Inc., a financial-services consulting firm based in Oakville, Ont., said thematic indexes — many of which embrace stocks across industries — have disrupted the conventional process of index construction based on sectors and subsectors.

Unfettered by traditional constraints, creators of thematic indexes can customize whatever they want to include or exclude. “There is no shortage of technically what you might decide to call an index,” Rebetez said. “Does that mean that everything that’s called an index is an index? I’m not so sure.”

Nor is there necessarily a separation of roles between the index manufacturer and the fund manager. Sometimes they are one and the same, or they’re corporate affiliates. This is true in mainstream asset categories, such as the factor-driven ETFs sponsored by Toronto-based Fidelity Investments Canada ULC, but self-indexing also crops up in niche categories.

The Horizons Psychedelic Stock Index ETF, for example, is designed to track a proprietary index created by Toronto-based Horizons ETFs Management (Canada) Inc. and calculated by Germany-based index manufacturer Solactive AG. Similarly, the index provider for the Blockchain Technologies ETF is its sponsor, Oakville, Ont.-based Harvest Portfolios Group Inc. Harvest’s index is also calculated by Solactive.

Self-indexing may provide cost savings for a fund company and greater flexibility than relying on an outside firm’s index, Rebetez noted. The tradeoff is that while the major index manufacturers and major fund managers have in-house expertise to ensure an index’s integrity, smaller firms may not have the same capability.

“Indexing requires reams of data, and data quality and analytics are of paramount importance,” Rebetez said. “With significantly lower margins than a lot of other financial products, ETFs need scale to offset. Smaller players may not always be able to shoulder the costs associated with everything required to ensure all aspects of their business are of the highest quality.”

Fund companies may also be turning to exotic index products for the glamour factor. The funds may provide a more compelling story to pitch to investors than plain-vanilla, low-fee indexing. “One of the things that I love about thematics or about disruptive technology is that they are very conversational. And they’re very relatable as well,” said Raj Lala, president and CEO of Toronto-based Evolve Funds Group Inc., which primarily offers funds in specialty categories. “These types of products have really helped improve client engagement for advisors.”

The marketing of thematics plays on the fear of missing out on the next great investment opportunity (which may or may not pan out). “The packaging of all of the products seems to be increasingly sophisticated and attractive,” Rebetez said.

He added that it’s uncertain whether specialty index funds — which generally charge higher management fees than those tracking broad markets — will deliver better results to inves­tors. In structuring client portfolios, advisors should consider whether the holdings of thematic funds overlap with broadly based funds.

Rebetez said advisors need to conduct their due diligence to determine whether thematic or specialty investments could be beneficial for a client: “A good advisor will remain open to understanding how the world is evolving and changing, but all the while also understanding the financial constraints and the objectives and risk tolerance of their clients.”