MSCI Inc. (MSCI) Earnings Call Transcript & Summary

[indiscernible] option. Here to discuss this, I am very excited to be joined by Dinank Chitkara, Senior Quant Researcher at MSCI; as well as Derek Devens, Managing Director and Senior Portfolio Manager at Neuberger Berman. So in terms of the format of today's webinar, I'm going to kick it off with a very brief intro then turn over to Dinank, who's going to talk more about how these new index options fit into the existing MSCI ecosystem as well as the liquidity and volume trends that we see in the existing products. And he'll also do a deep dive into the use cases, particularly focusing on how the new index options could help global equity portfolio managers more effectively hedge their portfolio. Then I'm going to turn it over to Derek, who's going to bring his wealth of experience on the buy side and talk about some of the institutional use cases that he sees for these MSCI products, his experience trading them as well as how he plans on using or sees using the new index option. So before I get started, a couple of housekeeping items. So we're going to hold -- as usual, we're going to hold questions to the end. [Operator Instructions] We're going to leave hopefully about 5 minutes for Q&A, and we encourage you to ask questions. If for whatever reason, we don't get through all the questions, happy to follow up one-on-one after the webinar as well. Great. So without further ado, let me get started by sharing my screen. Hopefully, everyone can see it. So yes, so what I'm going to talk very briefly on is our newly launched MSCI toolkit website. It is, I think, a great resource and a great hub for anyone who's interested in learning more about the MSCI suite of global index options. And a huge, huge shout-out to our Cboe marketing team for putting this together. What I have shown here is just a brief snapshot a part of the website. This, I think, is actually a great summary table of the products that are currently -- the current tradable products out there. So we have the 2 existing index options, obviously, on MSCI EAFE Index, ticker MXEA; as well as the MSCI Emerging Markets Index, ticker MXEF. Those have been out for a while now. But you'll also see in the blue highlighted are the 3 new index products. So MX ACW, which is the MSCI ACWI Index; MXWLD, which is the MSCI World Index; and then last but not least, MXUSA, which is the MSCI USA index. And this summary table just kind of shows you at a glance how many markets each index covers, the split between developed versus emerging, the notional side as well as the link to the contract specs, if you want to learn more. Again, this is just a kind of partial snapshot of the website itself. On the website, you actually find a lot more information. For example, we have a page that kind of compares the index options versus their equivalent ETFs. If you want to learn more about the differences between the 2, we actually have a couple of use cases. White papers published research and commentary from both Cboe and MSCI, all linked on the website. So I highly encourage everyone to go check it out. I put the link down at the bottom of the screen, but if you just Google Cboe MSCI toolkit, it should be the top link. So -- and again, thanks to our marketing team for putting this together. The other thing maybe I'll just highlight in terms of the notional size, and this is something that we did in response to customer demand. As you'll see, the notional size for the MSCI EAFE Index is actually quite large, and that's something that we've heard in terms of feedback from customers over the years that the large notional size sometimes makes trading a little bit clunky or like it's harder for retail clients, RA community to really incorporate these products into their portfolio. So when designing the MXCI World and MSCI USA indices this time that -- the option, we actually reduced the notional size. So the notional size on the options are 1/100th of the actual underlying index. So they are smaller notional size to make it more flexible, more dynamic for investors in terms of being able to incorporate it into their portfolio. In addition to these 5 tradable products that are currently out there, so it's 3 that just launched last week and 2 that have been out for years, we also recently launched 2 volatility indices. These are not tradable. So I think these are great tools to help investors monitor volatility of different regions. As we know, VIX kind of the benchmarked for measuring kind of volatility for U.S. equities, and these are meant to be kind of the equivalent for international markets. So VXMXEA is the volatility index for the MSCI EAFE Index and then VXMXEF is the volatility index for the MSCI Emerging Market Index. And both of these are constructed in a very similar way to the VIX, they are measures of 30-day apply volatility for the underlying indices. And what I've just shown here on the first chart on the slide is just the index value, so the volatility of the 2 different markets. The Emerging Market is in gray and then EAFE is in the dark blue. And you can see in terms of trends, very similar to the VIX, we've seen kind of volatility come in very dramatically kind of over the past year across all these different regions and volatility it's currently at or near 1-year lows across the board for all of these different markets. And the second chart I have here, and this is something that now that we have these different volatility gauges, you can also track which is the relative volatility of differences, right, the RV spreads between the region. So what I've shown here is just the relative volatility versus the U.S., specifically versus the VIX, to look at the different volatility between the different regions. In the blue, that's showing you the difference between EM versus SPX volatility. And then the gray is the EAFE versus SPX volatility. And again, similar trend, we have seen a narrowing of the volatility premium, I would say most pronounced or most dramatic in emerging markets. Actually, we highlighted at the beginning of the year, EM vol was particularly rich relative to developed because of the ongoing kind of sell-off stress in the Chinese market. But since then, with the stabilization of Chinese equities, we have seen that volatility premium shrink quite significantly, which you can see in this chart here. So that's what I'll -- I'm just going to stop here and turn it over to Dinank, who's going to talk more about the new index options that just launched and how those indices kind of fit into the existing MSCI ecosystem. So Dinank, please take it away and let us know how the kind of the entire MSCI ecosystem all fits together.

Sure. Thanks. Thanks, Mandy, for having MSCI on this webinar and everyone for joining. Before seeing how these products fit in the overall MSCI indexes universe, I should briefly describe the general MSCI approach for market cap indexes, which is now visible on the screen. This is a rule-based transparent methodology with the aim to cover the full opportunity set across markets, including developed, emerging and frontier markets, and can be used as building blocks for portfolio construction by both active as well as index investors. Exhibit on the right side shows the ACWI IMI universe, which covers 99% of the global equity investment opportunity set with over 9,000 constituents. This includes indexes or equity universes for developed markets, which is represented by World IMI Index; as well as emerging markets, which is represented by the EM IMI Index. As shown in the exhibit, these indexes covers markets across regions, namely Americas, Europe, Middle East as well as Asia Pacific. One main point to highlight is the IMI indexes include large-cap, mid-cap as well as small-cap stocks. Now if we move to the next slide, here, we see -- we record the MSCI ACWI Index. So yes, these are the standard indexes, that is they cover 85% of the investable equity opportunity set and include large- and mid-cap stocks only. This slide also highlights the options that Mandy had mentioned at the start of the webinar. Starting with MSCI ACWI Index, this represents constituents from 23 developed markets and 24 emerging markets, so in total 47 countries. There is World on the left side, which is 23 countries having close to 1,480 constituents, which is further split into USA, 600-plus constituents; and EAFE, 21 countries, 782 constituents. The only missing part in the developed market side is the Canada, where we currently do not have any options. And on the right side, there is EM Index where we already had existing options, which is -- which represents 24 countries and has 1,440 constituents as of Feb, last month.

Great. Could you briefly kind of talk us through some of the liquidity and volume trends that you see in the existing products?

Sure. If we look at the next slide, index options are a very valuable tool for investors. And that can be used for different purposes, hedging, leverage, enhanced income downside protection as well. Following the growth that MSCI saw in the Futures, we partnered with global exchanges to grow liquidity across a variety of index exposures so the investors can effectively deploy option strategies within their portfolios. On the right side, you see the plot which shows the EAFE and EM Index liquidity, linked options liquidity for the past 7, 8 years, which has consistently grown. Just to provide -- and this includes just the EAFE and index-linked options listed across all exchanges globally. Just to highlight one metric. For the past year 2023, there were 2 million contracts that were traded in total for these 2 indexes. And just to provide some additional perspective on the next slide, we also highlight the future liquidity for the similar universes, where we show the strengths in the volume motion across the contracts, across exchanges for the last 5 years, clearly showing that EM and EAFE have been the dominant ones.

Got it. Great. Yes. And I see that. Even though the world index options obviously just launched, there is actually quite a bit of liquidity and volume ready at the MSCI World Futures.

Yes.

Great. Then maybe like the next question I have for you, just talk us through some of the use cases that you see for these index options and maybe do a deep dive into hedging has been one that comes up time and time again for a lot of investors or how they can more effectively use these MSCI option -- index options to hedge their global portfolio.

Sure. So on slide currently visible, we see that derivatives in the overall investment process have a very crucial role to play. And this slide highlights some of them. These could be for benchmark replication; exposure management, which is around implementation of hedging strategies; competition overlays -- completion overlays, which is to align the planned exposure with targets; and could be tail-risk hedging, which is mitigating the large expected drawdowns. These specifically focus on one case study in the next slide there, which is based on MSCI World Index replication, which is a multi-country, multicurrency contract. There are a variety of potential methods when investors seek to replicate their global or regional index using index options, depending on the liquidity, transaction cost, which, in this case, could be premiums, and tracking error consideration. Some may choose to match the options with the index they choose to use to measure the performance, but others could turn to local index not directly linked to the index, whose performance is sought to be replicated and combine it with currency forwards. In this case, we assume 2 hedging indexes. These are simulated indexes. What we see is there is hedging index A which we construct, which is based on the top regional/country exposures of MSCI World. So in hedging index A, we are combining USA; EMU top 50, which is the European Monetary Union top 50 Index, Japan and U.K. And in hedging Index B, we just take 2 universes, which is USA and EAFE. And we try to simulate this by seeing that, okay, these are a selection of indexes taken from base the largest geographical exposures, and we wanted to minimize the number of indexes because at the end, those will be the consideration for investors. And to assign the wage to these indexes and this simulation, we ran an optimization that minimize the tracking error for the indexes. If you move to the next slide, we use MSCI Analytics to look at how the risk looks like for these hedging strategies. Clearly, the blue bar, which is hedging index A based on single countries and regions, is higher than the red bar hedging index B. This shows that there will be higher tracking errors or higher risk that the investor would be incurring even if they are not completely adhering to their benchmark. And the country risk and currency risk also get elevated when you use World Hedging Index A as compared to World Hedging Index B. So this was the equity part. In the next slide, we present 3 scenarios which will be because if you are using local index options, there -- you could be exposed to currency exposures as well, and those are additional risks. So in the first case, we have in which equity option and the currency denomination is indexed aligned. This is a perfect scenario. Given an example, you do not need an additional exposure for a USD investor who is using USD-denominated options linked to MSCI World Index. In the second scenario, equity option is indexed aligned, but the currency is not. In this case, a currency forward where we needed to match the exposures. And in the last case, when the equity option is not indexed aligned, you would need a combination of regional and country index options as well as noncurrency-based forwards based on the currency exposures of the index. So just to summarize, we just showed that if you try to replicate or hedge using a basket of local index options instead of multi-country, multicurrency contracts such as World, it could be even ACWI, EAFE and EM, such contracts, you incur a higher tracking error, which could be further amplified if there is higher currency volatility as well as lower regional or country correlations. So multi-country and multicurrency options help capture the index exposure in a single contract with less tracking than a partial replication or partial hedging.

Great. Thanks, Dinank. If we go to the previous slide, I think if there's an option C, which is just using MSCI World Index options, which obviously just launched, I would minimize, obviously even more, especially for U.S.-based -- like you said, a U.S.-based investor, right, because then they also don't need the currency hedging component. Great. Okay. I'm going to turn it over and I'm going to show the obligatory disclaimer slide, and then we'll turn it over to Derek. So let me -- okay. Perfect. So Derek, before I ask more about the MSCI products, could you just give a quick intro in terms of kind of your role and the strategy that you look after at Neuberger?

Absolutely. Thanks, Mandy, and thanks, everybody. Yes, so I run an index option group. We've been at Neuberger about 8 years now. We've been running the strategy. It's north of $5 billion in index option strategies for -- going on 14 years. So we're excited for the new product offering. I think the evolution of the index option space over the last decade or so is really what I consider the democratization of volatility. I mean for everyone to think about it as a volatility or as an asset class that people have been talking about for decades at this point is really starting to, I think, happen. It needed more tools, it needs things like this. So we're excited. We've used the Emerging Markets in the EAFE since they launched. We were kind of big adopters, had some unique clients with some, I'd say, unique needs. Every client has unique needs, but -- so we were early adopters there, having run global index strategies using ETFs and things prior. But again, I like this a lot to high yield 30, 40 years ago. These new issues come out, people realize you can trade them. People are able to hedge new vectors, do new solutions and take it more into an institutional class. And then also, I think, one off the top of my head, is great. Even just the contract size, being thoughtful there, being understanding that options are for all now, not just for the heavyweights. So yes, so we've been doing it. We're excited. Let me pause there. I can kind of go through some of our additional thoughts, but let me maybe stay focused.

No, that was great. Yes. So I think the first question to you is just can you walk us through some of the main institutional use cases that you see for the MSCI index options, both the new as well as the existing? You mentioned you've been trading the EM and the EAFE options from the beginning. How has those use cases maybe evolved over the years? Just kind of your thoughts there?

Yes. Again, kind of going back to the theme of democratization of volatility, in our mind, it's really the solution set. If you think about the S&P 500, and it's great. I mean we use -- I mean $6 trillion in open interest, seems to grow every year. People find new things, 0 days to expiration. I mean just -- but it's been the only game in town for a reason because there really hasn't been the global solution. And the EAFE and Emerging are great. But what happened, in my opinion, is they're very focused, right? You have to have an emerging market allocation. Then to get into Emerging Market options, you have -- other than hedging. So baseline, everybody always thinks of options as hedging. Oh, I got to hedge myself. I got to control risk in some cost manner. And so there was really no motivation other than specific strategies that we can get into. But the breadth of what you're going to do with just an Emerging Market index option is only going to go so far until you have what I consider the top level. So now when you have the World or the ACWI, you're really into the space of, hey, maybe I should hedge my whole portfolio rather than just beta adjust something to the S&P. Because again, the working model is that it's a wholesale market for risk. You used to have to go to banks. You used to have to go to others to lay off the risk, they would manufacture product to kind of control the risk structured notes, all sorts of things, hedging programs, systematic strategies, risk premia, you go down the list. And now all of a sudden, you have something that, as was illustrated, has -- actually matches the tracking error. You can actually put it in an institutional portfolio and not have the basis risk swamp some of the other merits, right? We've done a lot of analysis over the years where we were like, hey, this looks great. But then the basis risk alone makes it unappetizing for something that's looking for a couple of hundred basis points of tracking error or less. So again, I think when you start to talk about opening up world markets and hedging, that's kind of the baseline. Then you go into all the macro strategies and future strategies that have become -- so far there are CTAs. Well, CTAs and futures markets are just the other half of the option market. So now you're going to have both. And that led volatility, again, be much more of an asset or a strategy as opposed to just a tool. And so that's what we work with clients a lot. So whether you're going on offense or defense, whether you want to be global, you can think globally now without having to trade multiple just kind of like as you roll single names up in indexes, we love indexes. We don't like single names. Single names are idiosyncratic, you need research. You might as well be a long-only, buy-side stock research like we have here at Neuberger to try to and then price individual options. Those are for the big banks to trade and hedge funds do arbitrage trades with. But when it comes to wholesale institutional risk and carry trades and just go down the list. So that's why we're excited that you now have something that competes, I think, with the S&P globally because everybody is going to think globally. I mean the S&P has dominated the market for 20 years because it's the only thing that goes up all the time. I don't know that that's the case for the next 20 years. But again, let's not get into market views and let me kick it back to you.

No, that's great. And I think one of the use cases that we certainly heard from a lot of investors, a, it touches upon the diversification, kind of theme that you've already brought out, like S&P to diversify away, whether you're looking at hedging programs or yield harvesting programs. And the second is, especially at this juncture, right, like that -- the tactical views around how long can this U.S. outperformance last? How can that play this tactical, maybe like developed over U.S. views? Well, now we have a complete set of global indices, as we talked about, that people can express those views on.

Yes. And I would throw in there, one thing that I'm also a big supporter of it's going to make the option market that much more liquid, right? When you give the trading houses and you give the brokers -- not brokers, but the banks and everybody, the big, big desks different -- I mean because hedging the Greeks and options has always been a really big challenge because you can only do so much. And that's why like 0 days expiration options are kind of cool for traders because now they have basically daily liquidity with end-of-day expirations to control their second order risk. Now when you talk about the hedging global equities or wanting to create those hedges or the carry trades or what have you, the liquidity should get better because you now have kind of the big ACWIs and the big Worlds, so that you can have that volatility as well as just the S&P or the EAFE or Emerging. So that -- I also think it just facilitates a much healthier and probably more stable even trading environment and volatility over time, which again, I think, bodes well.

Great. So we talked about minimizing tracking error, which is obviously a big pro in terms of using these multi-country, multicurrency indices, as Dinank mentioned. One of the drawbacks or one of the things that people always bring up is liquidity, right? So I wanted to ask you about kind of what has been your experience trading the MSCI index option.

Yes, it's been really good. I mean, every time -- I mean, barring some de minimis size, we've been fortunate enough we haven't done this -- tried to squeak this into small portfolio. But we've always been well inside betas and close to mid. I think the markets are wide for kind of conservative. And any new product, they have to make sure they make some money or at least don't get whipsawed or what have you are taking advantage of. So the spread has always looked wide in the early days, but the liquidity is definitely there. I mean with -- as long as the futures trade well, there's really -- we've never had a problem getting it trade done. We've never had partial fills, just true to -- and pretty much any of the big index options or even the big ETF options. And secondly, look, not to get too far on the weeds, I mean there's a lot of volume that goes through the iShares ETFs with very similar risk profile. Wholesale-risk markets are going to love this idea that they're selling and buying and trading in one of the index option space, just like they do with the S&P and then get to lay that risk off or manufacture more risk, i.e. more revenue and profit for their desk by trading spies and ACWI and things like that. So again, that ecosystem is not just like looking at a stock and saying, "Oh, this bond doesn't trade. Oh, I'm sorry, the stock -- these spreads are too wide." No, they're just wide because the market maker needs to be careful. But then when you go to market, there -- we've never had a problem with the EAFE or the emerging market ones over the last -- I can't -- I'm going to say it's been at least 5 years, but time flies anymore. So the last 3 to 5 years, I mean we've traded billions of dollars in that space and have -- even the impact costs. I mean we have to report to some of our clients. And when we look at -- we're very close to mid, if we use mid as our boat if not better, sometimes. In a lot of bad situations, we've been through mid and much better on the selling side in certain days when markets kind of get a little nervous. So -- but let me pause there because I want to leave time for the question stuff. But yes, if anybody has any further questions on liquidity, I only expect it to be better in the bigger, more diversified index than -- like emerging markets has been very liquid. And you would think relative to other emerging market assets, that's not been the case, but in volatility it is.

That's great to hear. So yes, let me turn over to Q&A, and we already have a couple of questions in the queue.

One question, and I'll turn this over to you, Derek first. Just how are you planning on using the new options, whether it's ACWI, World or USA in your portfolio?

Yes. Right off the top is -- I mean we're not a big relative all our arbitrage. I mean we're buy side, but either -- just looking at 2 things. One, the relative volatility of it as a hedge versus some of the constituent indexes I think is a pretty interesting idea. So we'll look at that right off the bat just because we've seen -- volatility characteristics again and single name are -- is very idiosyncratic. You can't control it. But when you look at some of the currency, as that was highlighted, the currency risk is in these, which is really efficient and good for us as well. So you get again, that relative vol as well as just the hedging solutions we haven't had before. It's pretty expensive to hedge emerging markets with emerging markets. So over time, I think there's just -- basically the vanilla strategies that you haven't been able to do will have some unique elements because these are rolled-up big global indexes that now you can get a price for the risk on and volatility. And I'm expecting it to at times dislocate and at times to be even cheaper given the diversification embedded in them to probably carry volatility long versus being short some of the constituents. So those are the 2 big things, the hedging plan and all stuff. But then I do think the index vol gets a little more interesting.

Great. All right. The next question, I'm going to turn over to Dinank. And just a question around the trend of short-dated option trading. We have obviously seen that kind of explode in S&P and some of the other indices. What do you see in the MSCI index options space?

Sure. So I think if we talk about the 2 main like EAFE and EM options, which have been live for some time, overall, the trends within the 2 also have been quite dissimilar. For EAFE, just to give similarly to what we see in other U.S.-based contracts, we see currently the maturity of less than 1 month, if we categorize that as short-dated, now constitute around 65% to 70% of the option volume. And this has risen from 40%. It's a streak over 2019. Whereas for EM, this number is close to -- it has been in the range of 40% to 50% for the past 4, 5 years. Again, the distinguishing factor being that these 2 contracts are listed globally on multiple exchanges that's why the short-dated one is primarily the U.S. thing. I think other exchanges are still coming up with that.

Got it. Okay. And then one question, I think this is kind of interesting is just why did you guys launch EAFE and EM first before World and then ACWI.

Yes. So I think which options to launch, I think, depends on multiple factors. It would be AUM benchmark and also how the -- what the traction investors have already shown for other derivative products, maybe futures and ETFs. I think one of the slides that we showed, that was a prime example that why EM and EAFE were more prominent. I think the futures liquidity that we have seen, EM and EAFE are the most dominant contracts. That's why that becomes a much more go-to contract, and then this was then followed by other universes ACWI, World and USA.

Okay. Perfect. So we are currently exactly at time in terms of being at 9 a.m. We do have a couple of more questions. A lot of housekeeping questions just in terms of will the slides be available and replace the available. The answer to both is yes. We will send them out. Usually, it takes a couple of days to put the replays together. But sometime next week, you should be getting e-mail, everyone who registered for the webinar should be getting e-mail with the replay as well as a copy of these slides. So if we didn't get to your question, feel free to follow up with us individually after the webinar. And thanks again to everyone for joining today's webinar, especially thank you to our speakers, Derek and Dinank.

Thanks, Mandy. Thanks, everyone.