Morningstar’s Scale Helps Chart Its Course In Indexes

ETF.com caught up with Rolf Agather, head of product and research at Morningstar Indexes, this week at the Exchange conference in Miami Beach, Florida. The Morningstar benchmarks currently underlie 45 ETFs representing more than $102 billion. That’s a small portion of the more than 2,000 U.S.-listed ETFs that are passively managed, but it’s a growing number.  

At a time when issuers are looking to offer ETFs at the lowest possible price points, an index provider that is part of a large company like Morningstar operating at scale can offer the competitive pricing to meet that need. 

This interview has been edited for clarity and brevity. 

ETF.com: What is Morningstar doing in the fixed income space? 

Rolf Agather: We want to be a credible provider of indexes, just like the big three, and to do that, you have to go across asset classes. Fixed income is important in and of its own right, as an asset class, and we want to make sure we have broad capability there.  

But we also see opportunity for multi-asset and the ability then to appeal to an investor with a single index, potentially in a single product, spanning asset classes. The motivation for us is we want to be able to cover what is a fairly substantial asset class, not only for its own sake, but also in a multi-asset environment. At the product level, we basically built out a global bond family with a global aggregate [index], which includes regional variance, U.S. variance.  

Right now, we're adding ESG. The other big topic for us is that investors are now starting to include ESG considerations, and we see that happening in fixed income. So we're beginning to build out an ESG methodology on top of our broad global bonds for fixed income investors, and in a multi-asset framework. We're trying to bring all the pieces together across multiple dimensions. 

ETF.com: How is Morningstar looking to differentiate itself from the Bloomberg bond index offering? 

Agather: For now, we're trying to be an equivalent, but definitely [offer] better value. I'd like to think, just like we're doing on the equity side, we can have equivalent products that come at a better value.  

Our ability to combine ESG on top of that, through Morningstar’s Sustainalytics acquisition, will be a big part of that differentiation. When we start talking about ESG versions of global bond indexes, we’ll have the Sustainalytics capabilities embedded in them.  

ETF.com: Tell me more about Sustainalytics. 

Agather: Morningstar had a partnership with Sustainalytics, which was an independent firm probably in 2016, when Morningstar took a minority stake. It held on to that for a while and fully acquired them in the last year or two.  

They are one of the top providers of ESG ratings, both for equity and fixed income, so we have our own unique source of ESG risk ratings that we can then take into our indexes to create ESG versions. That's where we’ll really start to differentiate not only [with] the better value, but then as you start to look and see more ESG adoption, that'll show up in our [offering]. 

ETF.com: What sets the Sustainalytics methodology apart from competitors like MSCI in the ESG space? 

Agather: One of the concerns you'll hear voiced in the industry is that different ratings providers get different answers. We would point to the research.  

If you look at the MSCI risk ratings, they are more industry relative. When they talk about companies that that have the lowest ESG risk and their scoring framework, they tend to look at that by industry.  

In the MSCI framework, you'll have an oil producer that rates really high on their scale, because being industry relative, even in a bad industry, you're going to see good providers, whereas Sustainalytics is more of an absolute [approach].  

If you look across all industries, you'll truly see the better companies [and you might] see some sector biases there. Having said that, once you have an absolute measure across industries, it’s possible to do a relative [approach, and] we can get to their answer if someone really likes that for whatever reason. But we start out with an absolute [approach].  

The other [point] is that we're going to bring it all together again, as you look at all the other things that Morningstar does with respect to fund ratings. Sustainalytics information will permeate all of Morningstar’s business; it's not just an index story.  

When you think about manager research, equity research—all the other things that Morningstar does—we'll have a consistent approach. Sustainalytics [research is] currently applied across the funds that Morningstar covers from a reporting standpoint.  

Right now, Morningstar is able to calculate a carbon score across all of our fund universes, and we're using Sustainalytics data for that. There's a consistency across the organization [such that] we have low carbon indexes that are using the same data. That's just an example of where, at least within our firm, you're going to see a consistency across everything we do. 

ETF.com: How does Morningstar identify and isolate a theme? What’s the process for that? 

Agather: There's a natural tension between really identifying a theme early on but also wanting to find something that's relatively durable. You could identify what may be a theme early on, put money into it, and then it fizzles.  

Morningstar just published research from the fund side that basically talked about [how], of the thematic funds created in the last 15 years, three-quarters of thematic funds have been shuttered.  

For investors that maybe are more into—as I would call it—thematic speculating, that might be fine. You might want to invest in a portfolio and hope that one of them pays off. But we're more for people who want to find more durable themes.  

What we're doing in our equity research group is a combination of two things: understanding what might be an emerging theme [and] looking for companies that are involved in the theme. The two really go together.  

If you pick a theme, like renewable energy, how many companies are really in that theme? How many companies are really making money in that theme? [That’s] different than, “Are they just saying something in their financial reports?”  

For us, it's really about identifying something that's durable, that we think is going to have some durability and is going to be an investment that you can make for five to 10 years and benefit from.  

The second piece is that one of the ways we confirm that is we can find companies [that] we would say are truly making revenue in that space, or our analysts are saying we expect them to benefit from that theme.  

A great example was 3D printing. That's a theme that we’d identified a number of years ago [that] really kind of fizzled out. Even at Morningstar, there are cases where there was something we thought would be durable that [even with] our due diligence never went as far as people thought they would go.  

ETF.com: When do you decide to back off a theme? It seems some have a downswing and then a revival. 

Agather: Because we're putting it into an index, we've got to have more than three or four companies. There’ve got to be enough companies that we could create a meaningful basket of stocks that you could put in a portfolio.  

3D printing was a case where you basically saw the number of companies that we would identify as having a material benefit from 3D printing get to a point where we could no longer create an index. There are still maybe a handful of companies out there. For us, it's got to be close to maybe 20 to get some diversification.  

Another example would be in our renewable energy theme; we would have hydrogen as a subtheme. In terms of thinking about fuel cells and things like that, there's a case where we can identify maybe a handful of companies that are truly in the hydrogen space, but we probably couldn't build an index there. We'd roll it up into something else. 

If you're going to create a [theme] portfolio or an index, you have to have a certain amount of diversification, or you might pull in companies that aren't really exposed to the theme. 

ETF.com: Is a theme something that crosses sectors? Or is it something that drills down to a narrow slice of a sector, such as with biotech?  

Agather: I would say it can cross sectors. If you think about the general sector construct, your rule is every company has to be assigned to a sector, right? A great example is medical imaging equipment: Is that health care, or is it technology? Different providers might call it different things, but it has to go into one bucket. Themes potentially are more specific.  

But if we want to talk about health care innovation—that's one of our themes—we don't worry about if that’s health care technology. We try to identify within health innovation certain things like oncology or if the companies are involved in this specific area. And then we’d roll it up into what we call health care innovation. It's abstracted from sectors—that rule isn't there.  

If you ask yourself what makes a theme different than a sector, the idea behind the theme is really what we'd call a secular trend that’s being driven by some sort of macroeconomic force that will cause it to behave differently than the broad market over cycles.  

ETF.com: How do you handle companies like Amazon, which may be a leader in some theme, like cloud computing, but cloud computing is actually a very small portion of its overall revenue?  

Agather: That gets to the heart of the matter. If we were to construct an index around cloud computing, Amazon may not be in it. We’ll have a test, and it'll score lower. We have different thresholds. 

We have a scoring where a company gets a 2, a 1 or a zero. If you have absolutely no associates with a theme, you get a zero. If we believe that 10% of your profits are going to come from the business, you might get a 1. If it’s more than 50%, you're going to get a 2. Potentially Amazon would be a zero in our construct—it depends. 

Waymo [the self-driving car technology company] is a better example. Alphabet owns Waymo, but it’s [around] 1% of Alphabet’s revenue. We would say that’s not giving you exposure to the theme. It's not going to have an impact.  

Getting back to what we talked about earlier, it's this tension between getting in early versus getting the best exposure to something durable.  

Contact Heather Bell at [email protected]