Timo Pfeiffer is the Chief Markets Officer of Solactive and in charge of Research, Sales, and Communications. He joined in 2017 as Head of Research & Business Development, after working for more than 15 years at Deutsche Bank, where he has held various management positions in London and Frankfurt. Most recently, he served as Managing Director in charge of Structured Products distribution in Europe.
In this episode we explore the world of indices. You all have heard of the biggest indices, use them probably every day, but how much do you know about their origin, creation, administration? This is our topic for today. We look at the life of an index from beginning to end. Who comes up with the idea? How does the creation process work? What are the use cases? How to maintain an index? And in the end, what is the point of termination for an index? We speak a lot about trends and themes, like thematic investing, ETFs, sustainability, and much more.
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Andy, Luke & Leo
[00:00:04] ANNOUNCER: Welcome to The Wall Street lab Podcast, where we interview top financial professionals and deconstruct their practices to give you an insider look into the world of finance.
[00:00:24] AVH: Hello and welcome to the second in-person episode in the last two years of The Wall Street Lab podcast. I’m currently in Frankfurt in the office of Solactive. It started to rain outside so I’m really happy I could jump in. And with me today is Timo Pfeiffer. Timo is the Chief Markets Officer of Solactive and in charge of research, sales and communications. He joined in 2017 as head of research and business development after working for more than 15 years at Deutsche Bank where he has held various positions in London and Frankfurt. That’s actually where I know Timo, because he has been my boss, and a really good one at that. And now a couple years later I get the pleasure to interview him. So it’s really cool for me.
A bit more about him, he served as Managing Director in charge of structured products distribution in Europe of Deutsche Bank. That’s where I know him from. And he holds a bachelor’s degree from the Berufsakademie in Mosbach. This is definitely something we’ll get into.
[00:01:28] AVH: Timo, thank you so much for having me here.
[00:01:31] TP: Andy, thanks for coming over in that pouring rain outside. Also, you’re a neighbor here next door. And thanks for the lengthy introduction and some of the flowers there. I’ll be looking forward to that. Like you said, for me, it’s the first physical podcast again in more than 18 months. Did quite a few on Teams, Zoom and all of that. It’s good to be here socially distant, but in the same room.
[00:01:53] AVH: It’s amazing to have this experience again, because it’s one of my favorite parts about interviewing people is the personal connection. So let’s start with a bit of history. Like we knew usually have a career bit at the end, but just because I said and probably nobody in the listener group will know Berufsakademie Mosbach. How did you come from this like fairly unknown university and like, excuse my phrase, like in the middle of nowhere a bit to like be Chief Markets also at like company with over 200 employees now.
[00:02:24] TP: Let me think first of all for the right translation of Berufsakademie. I think it’s labeled nowadays as a University of Cooperative Education. And what interested me or got me started there like 25 years ago now is the mix of practical experience, in other words, internships and exposure to a company, and ultimately also sponsoring of a company, plus the academic part at the university.
It’s been back in the school days and prior to studying pretty clear that I wanted to end up in finance. I had no specific clue and clear direction age 15 or 16, but I knew what I wanted to do. And that’s been sounded like the best way in. So if I go to the traditional university studying business administration, focusing on finance, I would have done three internships and at the end applying for bank. So if I find a bank, which in this case, in my case, had been Deutsche Bank, to take me on board and sponsor me a student in the first place and from start with, it felt like, “Okay, let’s do that, because my direction of travel and ultimate goal to go into finance or banking has been clear from the beginning.” That’s the background. That’s the story that has worked out and that’s been my decision, yeah, what is it now? 25 years ago.
[00:03:48] AVH: It led you here. I did the same program also with Deutsche Bank. So I fully agree. It’s fairly unusual. That’s why I dig into it so early. But maybe we talk about career options later, definitely. Now, you have been in charge of sales and distribution for structured financial products. Now you’re moving a lot towards research and to a new company. Can you so quickly tell us what does Solactive do for the people that maybe don’t know it? And then how are you researching? What is your research focus here at Solactive?
[00:04:21] TP: So first of all, Solactive, in brief words, we do indices. We run, calculate, develop. And the more regulatory wording is administer indices. Indices can measure many things, many developments. But of course we are talking about financial markets. So I’m talking of performance and development of certain market segments. Think of probably the most well-known index on the planet, S&P 500, as the equivalent or measurement for U.S. large cap exposure. We do have equivalent benchmark indices at Solactive. We do have many variations across different asset classes and different segments and different style of indices we’ll probably get into as well. But that’s what we do as ultimately service provider for the financial industry, be it asset managers, investment banks, wealth managers, asset owners, pension funds, insurance companies that all use and consume indices.
And likewise, you’ve mentioned the time at Deutsche Bank, the under structured product side. I’ve been a consumer. I’ve been a user, structurer of indices and financial products ultimately myself. So that’s one of the use cases as an example what we do including, and we can probably go there more in details, research. What’s the suitable relevant index today, which is probably different than five years ago, and then another topic probably in five years?
[00:05:53] AVH: Absolutely. Thank you for the quick introduction. I mean, at first you think like, “Well, is the S&P 500 index right?” It’s like they are the typical big name providers. It’s rarely a core focus just to do indexing for them. Is it that you see you had a niche where you started? Do you have like a core focus on you saw a market need and like there was no index for that or they needed individual indices? Do we have any kind of core focus in the industries or any trends? Anything that is your strength that you would say?
[00:06:29] TP: Probably explain this best by looking a bit at the index market, and a bit of the competitive landscape, and the differentiating factor with us being relatively new in the game competing with, let me call them some of the large and major encumbrance, that are pretty much driven by brand and have over decades build up an awareness and branding. Let’s mention the biggest one, MSCI. We’ve just mentioned the S&P 500. You can look at [inaudible 00:06:57]. If I mention those headlines, and names, or brands ultimately, most people, at least in finance, immediately think of one specific index and the popularity around it. Those three guys that I have mentioned as market structure combine about 70% to 75% percent of the overall market. If I look just at economic theory and looking at that market structure, oligopoly, that’s typically not very good for customer service nor pricing. So in other words, it opens up room for disruption.
Our approach is different because I can’t spend and don’t want to spend decades of building up the same brand name and brand awareness, but rather compete, let’s say, on quantity of indices together with customization and flexibility, fast turnaround time, larger number of indices. So I can’t, and we don’t live on back of that one well-known trend index or branded index. But currently, as we speak, as you sit here, colleagues around us run and calculate more than 20,000 instruments and indices.
And the differentiating factor in order to get there, that’s ultimately an IT and technology game versus a brand game. If I try to explain that in short, as a difference and starting point, and let’s call it disruptive element that got Solactive started. Now, what is it? 14 years ago? And that helps us to grow or having grown over the last couple of years and is one of the, yeah, main ingredients, DNA of the firm in our business today.
[00:08:31] AVH: Let’s dig deeper a bit into this whole market structure of indices, right? I mean, you mentioned the big brand names, right? I think they’re fairly obvious they are there. I would be interested, are there indices – So of course there are, but could you give us a bit more flesh on where does actually most of the indices lie? Is it in equities? Is it in bonds? Is it alternative investments? And are those market forces shifting a bit? Maybe we can just start there.
[00:09:01] TP: Let’s start off all the examples I’ve mentioned, and all the big ones are typically equity indices. And the largest number of indices in the market is and probably will always be equity-focused. There’re a couple of explanations. Every stock is traded on an exchange. So while we talk, those prices are ticking. They are transparent. They are liquid. They are observable. As a difference, for example, you’ve just mentioned private markets, illiquid investments. Well, this wouldn’t be the case.
Hence, index construction based on equity, I was just about to say it’s easy. That’s not true. It’s the obvious starting point. That’s probably a better way to put it. But likewise, for all other asset classes, if I look at the big segment of fixed income, if you look at commodities, we label one segment complex. That’s effectively everything else from derivatives, option-based, futures-based, long-short. I had mentioned commodities. In all of those areas and segments, you can effectively measure the performance or bundle individual securities and instruments into a basket on index and measure those and have them calculated. So we are active across all of them. And the market indices exist in all of those different segments and granularity, but the largest part, and to some extent also most visible part, definitely is on the equity side.
[00:10:23] AVH: That’s the obvious, but I think it gives a good background. You already said you were a consumer. So the obvious use case for indices is to have ETFs. But I want to dig a bit deeper. What other use cases for indices are there? And maybe even ETF is just the one that is like touted the most by the general public, right? What are the use cases? And how would you say it’s distributed?
[00:10:52] TP: So you just said the most obvious there. I would disagree, because it’s the most public. And ETFs are a strong demand right now. And ETFs are a cool tool investment vehicle to give access to the market. And it’s also cost effective to get exposure to certain segments. And by definition, any ETF, exchange traded fund, is linked to a respective index as underlying. So that’s the most visible part. That’s what you can find on the web for any ETF on the planet. And if you look at the respective ETF, you will see like three lines down probably the index that’s height or the ETF is linked to.
We have just mentioned earlier on have 20,000 instruments or indices on the platform. About – What is it? 550 of those are underlying for ETFs. So that leaves us with a large number of indices that are less visible that you probably don’t see and that might be just a compilation of five individual stocks based on the research by some investment bank that this respective investment bank has traded with an insurance company behind it and ultimately is not visible to the public. Yeah, it’s just this insurance company, the investment bank. And I’m probably calculating that.
From my very own past and experience structured products, so principal protected nodes or certificates are quite popular. And another way to invest and many of these are linked to individual and single stocks, but fair to say that the largest part is linked to indices. And in particular, also thematic indices, one of the biggest trends. There’s sustainability, ESG. So there’s a whole range and variety of potential way to construct indices that are then as use case ultimately underlyings for structured products, tracking, or being referred to those indices.
Use cases expand. Let me just mention another one. If you’re an active portfolio manager and you run a super cool value-driven dividend strategy in the U.S., you want to measure your performance, again, the respective benchmark and need something to demonstrate or measure. You’re out or probably under and need an index as well to demonstrate on your fact sheet etc. So that’s examples for use cases that are pretty broad. No surprise, Andy, that you’ve started with ETFs, because, yes, they are growing. They are highly popular. And they are the most visible use case out in the market for sure.
[00:13:26] AVH: Yeah, that’s one learning from last week’s episode. The same thing in AI, right? I think there’s the public visibility and there’s the actual reality. That’s why I wanted to ask the question. I’m glad I did, because the answer even surprised me. And I’ve been with you in the same business, right? So let’s take the way of new indices, of new index, from start to finish in quotation mark, finish because probably the best of them are never finished, right? But where does it start? Does it start with an idea you and your research team come up with? Does it start with a client comes to you, “Well, I have a value-driven dividend strategy focusing on the U.S. and I need a benchmark.” How does it usually start with the idea?
[00:14:12] TP: So from birth to – Yeah, they can end. There is ultimately death of an index, which is when it’s terminated and not used anymore. But let’s look at the front and first part, birth process, construction process if you like. The starting point is always the idea. And that can be ultimate goal. Let’s call it like this. That can be a simple example like I want to measure a certain segment or sector in the market, Eurozone large caps, and look at constructing those. Obviously size being a criteria. Additional the size of the companies. I need to know which company are there in the Eurozone and ultimately rank them and sort and count to whatever level of constituents I want to have. So that’s a very simple, pretty straightforward index construction if I think of an equity, in my case, Eurozone large cap examples.
One of the first questions when constructing the indices, it’s ultimately a data game. Which data points do I need? In my example, it’s pretty simple, looking at size and jurisdiction. But it can go beyond from some financial data like price to book ratio, dividend yields, etc. I had mentioned ESG. So ESG rating and what’s the best data point to measure ESG. You just mentioned AI. So if I go and look at constructing thematic index, we do have AI-focused indices but establishing or figuring out and measuring which companies are relevant and active in the respective sector of your theme. It’s more difficult than just looking at size. So the starting point is and first question mark, which data points are needed and are available to construct and ultimately select the constituents for the index?
Ideas and those starting points can be different ones. I often like to say it’s coming from the market. It’s demand-driven, sentiment-driven. It’s what investors ultimately need, because that defines the use case. If you stick to ETFs and ETF that won’t have any demand and consequently raises assets is, ‘yeah, ultimately pretty pointless. So this helps as one of the main drivers for ideas.
There’s really different ways. One is, I had mentioned, investment banks or ETF sponsor that pretty much exactly know what they want. Come to us with a pretty clear framework. Then it’s a matter of quickly turning this around of a bit of back and forth and construction process, running back tests, finding the right data points, putting this together into guidelines and have to stay in the picture giving birth to the index. And likewise we are, that’s the research umbrella, constantly screening and browsing ideas. Being engaged ourselves in the market. You only have the conviction and think, “Hey, that will actually suit well or help solve a certain problem.” That clients or the market ultimately have. Then we support this, analyze this, yeah, through additional research. So really different ways this can start the life or kickstart life of an index.
[00:17:19] AVH: Okay. And then the idea came up. You check the data. Maybe for the sake of example, you made some research. You looked at just like, “Oh, actually it’s super interesting to invest into Eastern European small caps just because they have been very interesting over the last years. And nobody really has an index on that. But we notice there’s more demand for it.” You have the idea. It was like can we actually get the data? Where do we get the data from? I was like, “Okay, we have now free providers. We probably aggregated data to crosscheck.” We found the first client. The first client maybe an insurance company. It’s like, yeah, that’s actually exactly the exposure that I want, that I need. And then you sign them as a client. Then what happens then? What is needed to maintain it? Maybe they structure an ETF based on that, right? What is needed to maintain it? How does the child grow? What does the process look like? What tasks need to be done? What do you need to watch out for? Does it get complicated?
[00:18:25] TP: So actually a good example that you brought up, we do have a family called GBS, Global Benchmark Series. That’s our equity benchmark series that effectively you can slice and dice across different regions or individual countries and into different size segments, from large cap, mid cap, small cap. So in your example, I need to know which countries form up Eastern Europe. And there’s already different definitions, etc. And to a large extent most of those countries are classified as emerging markets. So you combine the respective equity benchmark of call it seven, eight countries into one region, emerging markets. And within that you effectively look at the smaller size companies. So small cap segment.
So good example because we have it – Your question is what happens when the child is born when the index is live? That’s run by our team called index management, or teams called index management. And that’s the really difficult and complex part. Also it probably sounds easy from the beginning, because you constantly need to screen typically on a quarterly basis and rebalance those indices. In other words, adjust and check. Is the size criteria still valid? Is still a small cap? Or as it moved up into mid cap segment or fell out? And below certain size threshold. Weight adjustments based on the weighting scheme of the respective index.
The largest part where I’ve said complexity comes from any corporate action. That’s pretty straightforward and easy if it’s a simple dividend payment. However, there, you already have different versions indices. Reinvesting dividends, of course, the dividend is important. So-called total return indices. Another indices disregard. So don’t take dividend payments into account. As a matter of fact most of the well-known, most well-known indices don’t reinvest dividends. So price return indices, you still need to know the dividend, but in this case don’t reinvest it. So dividends as an example for pretty straightforward corporate actions. But it starts to become much, much more tricky. If it’s a spin-off. What’s the treatment of the spin-off? It’s a takeover. A takeover from another region, in your example, outside of Eastern Europe. So what’s the parent company? Who’s the target? Who’s the takeover? That can lead to different definitions. That can lead to different interpretations. What’s the effective date? Is it actually really live or did it fell through two days after the announced target date? And all of this will have impact on the constitution and calculation of those indices.
So a pretty good example where the complexity and the tasks comes in. So it does not stop at what we just labeled the birth process and construction process. Life goes on. And getting back to the idea and technology point, that of course comes with a lot of challenges and needs to run the pretty stable and constant and scalable is probably the right word for a large, large number of indices. And last comment of what happens when indices are alive, is why we are talking, every few seconds, all of those indices I had mentioned are taking and publishing new levels based on the movements of, in our example, underlying stocks. So a lot of criteria to take into account. I hope to explain the gist of it. But it doesn’t just stop with the birth process. Not at all.
[00:21:54] AVH: I think that’s one of those things where I think, “Oh, come on. It’s just like you add up prices and you divide it by the constituents and then you have index price.” It’s not that easy once you get into the grits. Especially since indices, often, they need to be the reliance on indices for underlying products, right? At Deutsche Bank, if we trade with a partner based on an index and then the index would have been calculated wrongly, the exposures on like an investment banking site are huge, right? So you need to be able to rely on the index calculation. Everything is set up, because the difference for a structured product, right? If it maybe hits the barrier or it doesn’t hit the barrier of payout barrier and it’s just like a calculation error of an index, that’s a huge liability. So the devils in the details especially to have like the constant reliability.
[00:22:45] TP: Just one, if I may add, which is important. All of the process that I’ve just described and labeled as the complicated ones, it’s important that all of this is objective and transparent. So ultimately, let’s call it a bible for each index, an index guideline rulebook that clearly defines those criteria. So the nature of an index effectively is that whether you or I follow that very same and transparently laid out rules, the ultimately result has to be the same and transparent and understandable objective. There’s no – Not driven by any sort of subjectivity.
[00:23:24] AVH: Not all indices are created equal, right? It’s like if you invest in ETF, you maybe think, “Oh, actually this is very easy behind it.” But there’s so many differences. And maybe we can even get into some of the differences later between like what kind of indices are there to give people a bit more overview. But let’s finish this topic off and then, okay, you maintain anything over a year. What is usually the death place of an indices? Or why is it terminated? When is it terminated? Is it because the underlying structure product, for example, is no longer relevant? Is it because the ETF is discontinued? What are typical cases that why clients say, “No. We don’t need this index anymore.”
[00:24:07] TP: That’s both correct examples. So let’s just think of a new ETF being launched, a new ETF not raising the assets that the issuer was hoping for actually needs also to run and maintain the cost of this ETF and gives it a try for, I don’t know, let’s call it two years. And after two years realizes, “Hey, that’s gone out of favor. That doesn’t work.” And the ETF is cancelled. Let’s assume I have developed, we have developed that ETF only and purely for this ETF issuer and that individual and single ETF and that index is not of relevance elsewhere. Then, yes, it’s the respective termination of that individual or particular index. So often tied to the use case behind it, or thinking of thematic investments, certain themes might fall out of favor or simply not there anymore. Then, yes, that has an impact on tide index to it if there’s not enough stocks and companies active or even listed in certain segments anymore and you fall below, let’s say, five constituents, and the liquidity is not there anymore, then there’s no point in having an index linked to that. And it might get terminated respectively.
But often, also, to your point, products and respective structures linked to that, be it a fund, be it something on insurance side or a structured product, have a longer lifetime. So the lifetime is usually north of five years and beyond for respective indices. And we had initially mentioned the S&P 500. That’s around a very, very long time. And the very first one dating back like – What is it? End of the 19th century with the Dow Jones that had started there. So that’s also pretty, pretty dinosaurs indices out there. So there is no fixed timeline for any individual index.
[00:26:02] AVH: You mentioned one of the things that could bring down an index is liquidity. And I guess I know the answer, but why is liquidity important? Is it because then you can’t get enough prices to update the index regularly? Or is that – And then maybe leads to another thing that you call complex indices. Are the indices where you from this get goes, say, “Well, we know we only get one price a day, one price a week sometimes is a very complex structured index, or like alternative indices.” Is this something that on the one side might be the death sentence for indices, but in other indices is like embedded in the product and like it’s known? Or do you always need – Well, we need a certain liquidity, which I guess translates that we need a certain amount of prices to provide this index.
[00:26:59] TP: It’s actually less of an index question. It’s more what’s the respective use case behind it. So if you want to evaluate the value of this building we’re sitting in and you have a price every year and you somehow get to a transparent price source. To have that price, one constituent times this price, I can calculate and publish a yearly index. It’s probably not relevant and not helpful. And just a use case that you want to know the value of this building, which is difficult to establish. So translating it to real world and the financial world any of the underlying instruments need to be tradable, not because of me on the index side, but otherwise there’s not really a use case for a product provider, for some bank or as a manager, or anybody investing money in that direction.
So the important part is that those prices are transparent observable and not just something that you and I had agreed, but on some usually marketplace and exchange, which is the most transparent part of prices, or I think of bonds evaluated prices and not just some bit offer levels at a certain point in time. So it needs to be transparent objective and from some, call it public or reliable source in establishing the value.
So going back to my random example of the building, if that level once a year is done on basis of five real estate experts here in Frankfurt, okay, that can be a price source. And taking their average, it could be an established price source. But the main driver for liquidity and where do I get prices from actually comes from the user, banks, asset managers behind it.
[00:28:42] AVH: Interesting. Now, talked about quickly, briefly, you mentioned there’s dividend adjusted indices. There’s like reinvested indices. What other type of indices are like, say, the 80%? I mean, there’s probably some really, really complex structural indices. But what are the typical ones? You mentioned the S&P. I know like of the German tax index. What kind of indices are there? And could you give an example of what is the typical indices? Because I think people know, yeah, indices are this thing, but they might be quite different depending on if they reinvest dividend or not, for example.
[00:29:20] TP: If I try to categorize that the biggest part, most well-known part, and pretty much everything we’ve discussed about so far is let’s call it benchmark indices. Mentioning the S&P 500, or let’s call the equivalent, Solactive U.S. large cap index is a benchmark, in this case, weighted by size, market capitalization weighted index representative for certain segment of the market. Yeah, that’s true for you’ve mentioned the darks. That’s true for any major country index. And the same holds true on fixed income side. So largest bucket, definitely benchmark indices.
Currently, a lot of Currently, meaning over the last couple of years, a lot of demand and developments in thematic investing. We had mentioned AI. A lot of disruptive technologies changing the ways we live and behave. A lot around digitalization. That can be a cloud technologies index, cyber security index, different versions of future of mobility and how is our life going to change, and electric cars, electric vehicles. That’s all examples of thematic indices also most often in equity space that we have developed and that the market is looking at and developing. So thematic investing.
And you wanted to cover 80% of the market. The biggest driver momentum, I don’t even want to call it trend, but development in finance and probably the society of all is anything related to ESG. So ESG sustainable. Investment strategies and consequently indices with a large part, and a good example in the e-part of ESG. So climate transition, climate reduction, climate efficiency type of indices.
So to translate this into our birth and process of running and maintaining indices, of course in order to do a climate strategy, I will need to have respective climate CO2 emissions and climate data for the underlying companies in order to be able to construct an index where the portfolio or the index is following a certain pattern, reducing the carbon footprint of the portfolio overall. So really, benchmarks as a large part thematic indices with a lot of new developments. And the biggest driver or development in the market overall consequently also indices, for sure, is another segment of ESG.
[00:31:46] AVH: It has this in a lot of conversations that ESG is the new thing, right? There’re a lot of trend indices. And that was actually one of my questions. What are current indices trends? And a couple of episodes ago I spoke with Howie Li from Legal & General who also do – I guess you know him, because I know they – That’s I quickly checked that I had the right sense. They do a lot of selective indices as basis of their ETFs. And I know that they have a very, say, involved structure in structuring the ETFs and the constituents that they put into their ETFs, so hence, into the indices. Who usually changes, for example, constituents? Or who does the research? And that may be like a good transition into your role as Chief Researcher at Solactive. Especially in those trend categories and especially in ESG, do you drive a lot of the research in, for example, AI, and then you do the AI research? Or is it then a partner company? Is it both? I kind of just want to get a sense of like who decides what is the cyber security company that we should track in these indices.
[00:33:03] TP: So let’s take this opportunity. Greetings to Howie and the team in case they will be listening. It is good examples of thematic ETFs here with respect to ESG criterias. The quote or sentence who decides is something I didn’t like and showed some reaction to. Getting back to the point it has to be objective. So what we have developed as probably a good example for research is some, I don’t like the terminology, AI, but some algorithmic-based NLP, natural language processing algorithm helping to define, let me call it relevance score of a company, versus a respective theme.
So let me give an example. If you think of Amazon in a traditional sector classification, Amazon is a retail company and an online retailer, because that’s what they do. And if you simply look at their revenue numbers, that’s the absolute elephant in the room. Looking at thematic indices, if you think of a construction of a cloud technologies index, you probably still want to have Amazon in there because they happen to be also the largest player in cloud space. So that’s an example where let me call it sector classification or theme definition, sector classification 2.0 through such an algorithm, as an example, helps to define this relevance score. So it’s still and a very factual number, call it rank, relevance score to a specific theme, that ultimately helps to construct the index. And also if I think along the lines in a frequent adjustment of the index probably review every six months to then adjust the portfolio in case new players have emerged or the relevance to the respective theme or the ranking to the respective theme has changed. That’s part of the index job.
So getting back to Howie or the ETF team there, it’s not a subjective decision at all on the product side. This is an objective or the output of an objective set of rules that happens on the index side and is defined in that guidelines I had mentioned earlier. So example for thematic investing, still following and following the objective set of criteria and rules. However, you don’t find the public list ranking companies by activities in all the different level of granularity that’s out there. So cloud technology is a good example.
[00:35:37] AVH: I mean, it makes sense, because what you said before, it has to be objective. And I like you said it’s an algorithm, not an AI. Because I just know from the fintech space like everybody says it’s AI, but it’s just an algorithm, says, one plus one is thee. Or no, it’s wrong. I try one plus one equals two, and they call it AI. But especially in your case, it has to be objective. And you can’t go if the buffer knocks on your door. It’s just like, “Hey, I want to check this that you’re actually doing it right.” It’s like, “Well, the AI came up with new constituents, right? It’s just very difficult to say. But how do you then decide what is theme that’s coming up, right? Why is it cloud, and why is it cyber security, and why is it not diesel cars, right? Where does the idea come from what to research, right? I mean, you’re an observant guy. Like do you walk around as like, “Look, what is happening in the world?” Or like where do the ideas come from? Do you have like a team that does nothing else but just scanning news articles? Could you tell us a bit more about the process of where you decide to put your efforts, because there’s unlimited, infinite opportunities to research something.
[00:36:47] TP: There actually is, and a blunt way to put it is reading the papers helps. So you’ve just gave a good example on diesel. Yes, you read a lot about diesel. But from what I read in a negative sense and from how long are those engines still going to be around? Is it 20, 30 or 35? And that’s probably right now some behind closed doors conversation in the German coalition talks. So that’s a good example, because diesel is in a negative sense. And on the contrary you read a lot about electric vehicles, and battery, and battery technologies. By the way, that’s one of the ETFs and indices with legal in general. So it’s more definition of, for sure, future mobility electric vehicles and batteries around that are a trend and a theme. And that’s not just new. That’s a trend in theme since three to five years, let’s say.
But the research work and part is then how to define that if I just mentioned batteries starting off negatively diesel, positively electric vehicles. Then looking at this you quickly go to batteries. Then what type of batteries? Who are the producers? Who has the right technology? Thinking here you’re in my home turf in the Southwestern part of Germany. It’s all about cars. Those guys have probably been slow in adapting to the new reality and electric vehicles. Now there’s a quick catch-up game and a lot of good developments in that sense. Yeah, that’s examples in part of research world task.
The honest truth is also not every idea that sounds cool and great and like the next big thing at the beginning ultimately will see the light of day and ultimately will make sense and work out. So the frustrating part is that a large part of this world ends up in the bin. But just talking to people, listening and looking at trends and what’s happening in the world around us helps to find those themes, ideas and define them.
[00:38:40] AVH: I also saw that you do a lot of different kinds of research. Not only trends, but also something like what’s the effect of liquidity. How can you implement different dividend strategies? So there’s so many how do you best reconstitute indices? What drives it? Is it the key driver of that part of the research to increase performance of indices or make them generally more efficient? How would you describe the idea behind, for example, looking at different dividend strategy, reconstitution? This is to help your clients create better indices?
[00:39:15] TP: The largest part of pretty much everything around research we’ve discussed till here is what I would label thematic or qualitative research, or themes, and trends, and company exposure, and by definition, equity-heavy. The second aspect in part is we label this quantitative research often in large part, also called factor investing. So which factors actually drive performance in the market? I wouldn’t always – And just label this as improved performance. Having performance more robust or more defensive in downturns, thinking at volatility or low volatility as a potential factor driving performance. You had mentioned dividends. One of the key ingredients if I think of value investing and value as a factor, that’s all part of quantitative research and different use cases most often than the what are labeled qualitative or thematic use, thematic research.
So quantitative, much more mathematical call it, or formula-driven, formulaic research and analysis. Not just simply with, “Hey, it needs to perform better.” But if it performs in line but the strategy or the respective factor and research shows that it’s more stable in down markets, that’s probably something you want to have to add a layer of protection or more conservative approach, yeah, when things get sour.
[00:40:48] AVH: I think this quantitative part is really interesting, because in a lot of the conversation it comes up more and more that I think even Howie said exactly that. He realizes more and more indices are quantitative. I speak even to venture capitalists and say like, “Yeah, we have a lot more quantitative strategies now.” Is this something you also see that quantitative strategies are slowly taking over? Are they getting more important? Or what are the – Aside from ESG maybe, what are the biggest upcoming parts in the indexing world?
[00:41:24] TP: That’s not necessarily linked to whether it’s qualitative or what I mentioned Thematics. You’ve asked for biggest trends. One of the other biggest ones that we haven’t touched upon yet is definitely costs. And that’s on back off, let me say, cost pressure in the overall financial markets. Or let’s call it cost awareness. That’s one of the drivers. You had mentioned the segment of ETFs and costs only going one way. And let me label this race to zero. And indices and index construction, and we can get to performance impact. And one of our research in the quantitative space is actually labeled hidden costs of index re-balancings, yeah. Not hidden in the sense that it’s put somewhere under the carpet, but implicit indirect cost and ways how to more effectively rebalance indices. Like not everything, the whole market, the whole world at one day, because it clearly is a function of liquidity and would have a performance impact. How to, number one, measure? And number two, would probably better manage, or run those performance impacts?
That would be one element of quantitative research. That’s highly relevant if you manage money and are, of course, cost and performance conscious. So costs by the sense of price tag, but also costs on what’s the impact of my portfolio is another main driver. Of course, increasing cost awareness, in particular, in passive investment. I want to make this larger. And look at passive investment and not just ETFs. That’s one of the key ingredients why there’s such a strong momentum and flows going and coming from active into passive. Yeah, it’s about, let’s call it efficiency.
[00:43:08] AVH: It sounds like you also think a lot about the user of the industries and how to drive down costs for the user, because it’s not that there is probably a certain cost to updating the prices now every day or to like rebalancing every day. But I guess it’s mostly automated. So the cost is fairly low on the index side for you. But that means you also think about what would the real life, the trading of that index look like if I kind of want to benchmark against it, if I want to really put this into practice and like actually buy the shares and that like how I build an ETF based on that. And there’s also a strong driver of your research on how you can create indices that are actually maybe call it more applicable in real life or optimize the real life. Not that indices are not real life, but I hope you know what I mean.
[00:44:05] TP: No. Absolutely. That’s one of the key drivers and actually one of the mission statements we have. It has to be relevant for the market and not just theory and probably nice book putting somewhere in the shelf. No. Reality matters. And that’s primarily thinking of liquidity and activities around that. So even your random example, if, “Yes, I could construct an index within and out every day.” And we have intraday rebalance indices for certain strategies. But if you think of a large benchmark index, a daily adjustment probably looks nice on paper. But the moment I talked to an asset manager and telling him, “Yeah, by the way, you need to go and sell for a large amount shares every day.” That’s not going to be effective. That’s not going to be efficient. That’s not going to help performance for his investors or himself and the asset manager at the end of the day. So yes, relevance, let’s say, to real life and the market out there is an absolute must and a key ingredient for not just research, but all the activity we do. Otherwise it’s frankly pointless.
[00:45:09] AVH: Now I’ve given the quick hint that this is coming. And I think we’ve learned now so much about indices and we know like what are the key trends. And now just as from your experience, right? Many of our listeners are young professionals, are students, who basically made it not to play down at all like the cooperative state university, but like to see chief markets officer of this large startup or like this large company. Could you give the listeners that are looking towards, “Do I do my master’s? Do I do this education?” And remember, I had this conversation with you before I started my master and you said like, “Hey, do your master’s. It’s going to be fun. It’s just going to be an experience.” Would you say people nowadays, if you’re looking to hire someone, are you looking like, “I don’t care if you have a master’s. I don’t care if you have a Ph.D. I care about your experience.” What is it that you would recommend people and what you are looking for if you have an interview?
[00:46:11] TP: It’s different times nowadays. So my example and experience and starting point like 25 years ago is different times. It’s been about door opener into an investment bank. I have started straight after university at Deutsche Bank in London. And from the moment I’ve put a foot in the door no one has ever asked me anymore, “What did you study, and where did you study, and what was your grade?” But it’s been this exposure, call it door opener, has been extremely helpful and the main benefit of getting in, no doubt. And since at the time, at the beginning, no one has ever asked exactly where and how did you study, so then let’s call it real life starts.
If you say and probably ask whatever seven, eight years ago, or if you ask me for views today, there’s a change at my time. I think we’ve been the first year where the bachelor got introduced and available in Germany. Yeah, and now this is a must-have and international comparison. You have a completely different competitive landscape if I think of starting your career. So of course that counts and masters and the bachelors, and your respective degree and grades around it.
For me if you ask me and if I look at recruiting, that’s not the main driver. Let’s call it the minimum threshold. And frankly, if I probably call this some stage advice, there’s too much focus on what’s my grade, and where did you study, in which university? To me that’s secondary. Primary is the person. Ultimately, I don’t hire grades. I hire characters and personalities. And the question is not what have you done and do you know today. What do I really jointly think you can be capable of in two or in five years’ time. Yeah. And that’s why I say, of course, degrees, grades are a minimum threshold and it’s probably an indication. If you didn’t finish one or had constantly and extremely bad grades, that’s probably one side. Still interested to talk to you and see, “Hey, why is that?” And understand better.” But it has changed. I think I’ve mentioned personality, character. If I put this down, attitude is probably the right word. That’s an important ingredient that you don’t necessarily learn during your master and at university. But in real life, when you start your career, to me, it plays an important role. And it can be a differentiator for a new starter compared to everyone else that has the same degree, and the same good grades, and all those certificates, and courses, and Python skills.
[00:48:42] AVH: How could you demonstrate the right attitude? Say, is it that you’re just like, “I look for certain things in a CV. Or I look for certain things when the person walks into the room.” Is there any tips that you would give out to listeners as like, “Hey, show me your attitude is right by doing X, Y or Z.”
[00:49:02] TP: I have said, times have changed, and it’s an amazing opportunity right now the average education, the access to university and courses has significantly changed, and is a foundation and a great education. It’s about which question do you ask first. Do you come here for an interview? And you say, “What do I get? And what’s the offer?” And I’m super cool because I know everything and I’ve been to that great university.” Or is it if I mention attitude. Okay, now I have a starting point. What do I need to give what the expectation? What do I need to do to excel and ultimately learn and bring to the table, which then as, let’s say, development paths, hopefully and potentially, career to follow. So that’s a good example. How do I ask the question? Is it more like, okay, consumption mode? What do I get versus what do I bring?
[00:49:55] AVH: Awesome. Timo, it’s been so much fun. I learned myself a great deal about indices. I think some really fantastic career advice in there as well. And let me just personally thank you for all you’ve done to inspire me to do what I do. And it’s been great to catching up with you. And if you have anything, any last words to own listeners, please now is the time. And otherwise, I hope you have a great day.
[00:50:19] TP: So any last words? I need to be quick. Indexing is mainly driven by passive asset management. That’s the future from day one. You’ve asked university. I have invested index-based and quickly and painfully realized stock picking is not for me and not going to work out. So good luck for whom it does. But in the long run, indexing is the way to go. Think of that as an area in life where you’re happy to settle for the average. If you think of a benchmark and just by the market, saves you a lot of hassle. And I think ultimately it works.
Andy, to you, thanks a lot for being here. Thanks a lot for having me here. We have started with pouring rain. Now there’s sunshine outside. And yeah, thanks for all those questions. And I hope we could give some insight into your listeners and if there’s questions, follow-ups, anything that has been unclear. Yeah, you know where to find me. And I guess you post this online. Thank you very much.
[00:51:10] AVH: Thanks, Timo.
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