About MSCI’s Global Innovation Indexes
In our recent article on innovation management, we looked past the buzzwords to talk about the importance of constant improvement at a company-wide level. Says Wikipedia, innovation is “the application of better solutions that meet new requirements, unarticulated needs, or existing market needs.” Investment management firm ARK Invest takes this a step further by defining “disruptive innovation” as “the introduction of a technologically enabled new product or service that should transform economic activity by creating simplicity and accessibility while driving down costs.” The firm has identified “five multi trillion dollar innovation platforms” as seen underlined below:
We recently looked at the top-ten stocks in the ARK Disruptive Innovation ETF which has now amassed over $1.6 billion in assets. The top holding is Tesla (TSLA), a company ARK believes will be a leader in the $7 trillion autonomous vehicles industry because they control all the data. More recently, ARK Invest has been collaborating with global index provider MSCI (MSCI) on a handful of innovation indices.
MSCI – A Global Index Leader
You may recognize the acronym MSCI from the global index names you see mentioned on popular finance media channels. For example, MSCI World is a popular index that measures the performance of equities in all the world’s developed markets. The acronym MSCI stands for Morgan Stanley Capital International, and the company started as a division of Morgan Stanley that was spun out as an IPO in 2007 priced at $18 per share. Today, those shares trade at $379 a share which equates to a return of just over +2,000% in thirteen years
MSCI’s growth is fueled by their cash cow index division which maintains a global universe of stocks that can then be sliced-and-diced by factors such as geography, growth vs. value, size, momentum, and just about any other dimension you can think of including innovation. Thousands of indexes are produced every day, some real-time, and many customized to a specific client’s needs. Many of these indexes then end up being used to build exchange-traded funds (ETFs).
Now, MSCI is taking this same global universe of stocks and carving it up into four different thematic indices that focus on innovation:
- MSCI ACWI IMI Autonomous Technology & Industrial Innovation Index – 446 stocks
- MSCI ACWI IMI Genomic Innovation Index – 200 stocks
- MSCI ACWI IMI Fintech Innovation Index – 156 stocks
- MSCI ACWI IMI Next Generation Internet Innovation Index – 385 stocks
Each of the above indices contains a number of constituents that are subject to change based on input from MSCI’s research team and also ARK Invest. Says MSCI:
The Component Indexes are subject to expert input, information and insight from ARK Invest that is consultative in nature and is utilized by MSCI at its sole discretion.Credit: MSCI Methodology
There is also a fifth index – the MSCI ACWI IMI Innovation Index – which is simply a compilation of all stocks found in the other four indexes.
Let’s look at how they’re building these innovation indices.
The MSCI Innovation Index Methodology
The process starts with a parent index, in this case, MSCI ACWI IMI. All these acronyms simply mean that this index represents all stocks around the globe, in emerging markets and developed markets, that are investable. (In other words, none of that penny stock garbage.) They now have a universe of stocks to choose from. Let’s look at how they select index constituents using the MSCI Genomics Innovation Index as an example.
MSCI starts with “a broad set of relevant words and phrases derived from the index objective.” For example, below are some of the business activities they’re targeting that relate to the genomics theme:
- Gene Editing
- Agricultural Biology
- Molecular Diagnostics
- Genome-related hardware for analytics and diagnostics
- Targeted Therapeutics
- Gene Therapy
- Stem Cell Therapy
They then take the keywords and evaluate them against company-level data that includes:
- Business segment information from company annual reports and vendor data sources: business segment names, assigned SIC codes, and related revenue
- English language summary description of the company’s business activities
Basically, they’re trying to figure out where a company’s revenues are coming from and what percentage of those revenues can be attributable to any given disruptive technology. The end result is a relevance score which indicates how “pure-play” the stock is. For companies that don’t have any revenues yet, “the relevance score calculation takes into account the portion of company’s asset in place of revenue which may be tied to the selected business segments.”
We ultimately end up with a portfolio of 200 genomics stocks (as of Jun 30, 2020) which provide investors with exposure to genomics. Here’s a look at the top ten constituents of the MSCI Genomics Innovation Index as of Jun 30, 2020:
Twice a year, the “semi-annual index review” takes place, a process that you can think of as “index maintenance” where companies are added or removed. This churning of constituents is also called “index turnover,” and the index fact sheet cites a turnover of almost 25% over the last twelve months compared to just 3% for the parent index. This seems to conflict with the belief that longer-term holding periods are needed for the “exponential value” of disruptive technologies to emerge.
Not The FAANGs Again
MSCI’s Autonomous Technology & Industrial Innovation Index is perhaps the most interesting of the lot because it looks across such a wide variety of disruptive tech themes. From the methodology:
Here’s a look at the top-ten stocks in the MSCI ACWI IMI Autonomous Technology & Industrial Innovation Index:
Definitely some of the usual FAANG suspects, but also the inclusion of stocks that wouldn’t be traditionally classified as tech, but arguably should be. (That’s a problem that BlackRock is solving with their “iShares Evolved Sectors ETFs.”) There are stocks from around the globe, not just ‘Murica, and the weightings are quite different from a typical tech sector index. For example, the “MSCI World Information Technology Index” has Apple with an 18% weighting and Microsoft with a 16.5% weighting.
The other thing to note about this index is that active decisions are being made to penalize or filter out particular GICS Sub Industries. From the methodology document:
If a stock is classified in any of the GICS Sub Industries listed above in Section 2.7, they’ll need to have twice as many mentions of the magic keywords to be moved forward in the selection process. Keyword stuffing the SEC filings won’t help any, because MSCI is also looking externally to see how people describe what a company does.
If a stock is classified in any of the GICS Sub Industries listed above in Section 2.7.1, they’ll be excluded from consideration regardless of what words they use to describe their business.
In both these examples, MSCI is making active decisions to penalize or exclude certain sub-industries based on their research and consultations with ARK Invest.
We’ve talked before about how ETF creators will sometimes have a hard time finding constituents, so they’ll just start adding anything that looks remotely related to the theme they’re targeting. Oftentimes, the end result for the retail investor is a selection of ETFs that promise the same thematic exposure but that each contains a dramatically different set of stocks. MSCI’s innovation indices use a process that’s both rigorous and objective in hopes of solving that problem.
For those of you with more than a passing interest in how MSCI’s innovation indexes are built, you will find all the details in the Nov 2019 document titled “Indexing change – Understanding MSCI thematic indexes.”
In our recent piece on Scottish Mortgage Investment Trust, we talked about how 95% of active managers can’t beat a benchmark. Why pay more for active management if it doesn’t outperform? If you’re going to pay for active management at all, you should demand meaningful outperformance. In order to do that, you can’t just tinker around the edges of an index, you need to take some proper active bets. For those ETF providers that are trying to take active bets on which stocks provide the most pure-play exposure to various innovation themes, MSCI’s indices now give us something to benchmark them against.
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