MSCI CEO on Private Assets, Climate Change, and More | At Barron's

Key Concepts

• MSCI (Morgan Stanley Capital International): A global provider of investment decision tools, including indexes, portfolio analytics, and ESG ratings.
• Index: A statistical measure of the performance of a specific group of securities, used as a benchmark for investment portfolios.
• Subscription-based model: MSCI's primary revenue model, where clients pay for ongoing access to data and services.
• Asset allocation: The strategic distribution of an investment portfolio across different asset classes, considered more impactful than individual security selection.
• ETFs (Exchange Traded Funds): Investment vehicles that trade on exchanges, similar to mutual funds but with potential tax advantages.
• Private markets: Investments in assets not publicly traded, such as private equity, private debt, and private real estate.
• ESG (Environmental, Social, and Governance): Factors considered in investment decisions to assess a company's sustainability and ethical impact.
• Climate change: A significant global trend impacting capital markets, creating both winners and losers in investment portfolios.
• AI (Artificial Intelligence): A transformative technology with significant implications for capital markets and MSCI's operations.

Backstory of MSCI and Henry Fernandez's Role

Henry Fernandez recounts the origins of MSCI, which began as a joint venture between Morgan Stanley and Capital Group around 1988-1989. In the late 1990s, Fernandez, then trading equity derivatives at Morgan Stanley, explored establishing an entrepreneurial venture or developing a new division within the firm. He identified Morgan Stanley Capital International (MSCI) as a potential foundation for an "investment tools company" or "investment infrastructure." At the time, MSCI was a small, largely cost-center operation with about 60-70 employees and global clients, subsidized by its parent companies. Fernandez took over MSCI as a "night job" and, after two years of growing interest, formally committed to running it full-time in 1998. He restructured the relationship between Morgan Stanley and Capital Group, laying the groundwork for MSCI's evolution into a diversified investment tools company. The initial product, market capitalization indexes, became a cornerstone of the business.

The Proliferation of Indexes

MSCI calculates approximately 250,000 indexes daily, with about 10,000-15,000 calculated in real-time every 15 seconds. This vast number stems from the need to represent the permutations of investable equity securities globally. Fernandez likens this to the limited number of primary colors (stocks) that can be mixed to create an enormous variety of shades (indexes). These indexes allow investors to create specific exposures, such as "mining companies in Brazil," "full companies in Japan," or "telecom companies in emerging markets," by combining and matching different criteria.

MSCI's Business Model

MSCI operates on a subscription-based model with three main revenue streams:

1. Fixed Subscription Fee: A recurring fee, adjusted for inflation, for regular delivery of index values, risk models, or ESG ratings. This constitutes about 22-23% of revenues.
2. Variable Asset Management Fee: The majority of revenue (approximately 75%) comes from fees that vary with the assets under management. As client assets grow, the fee percentage remains the same, but the total fee increases.
3. Transaction-Based Fees: The smallest revenue stream, derived from fees on transactions that take place.

Client Base and Service Offerings

MSCI serves approximately 78,000 institutional investment clients in about 100 countries, representing the "who is who" of the investment industry. Clients utilize MSCI's offerings for:

• Market Cap Indexes: Including fixed income and non-market cap indexes (55-60% of revenues).
• Risk Management Tools: MSCI is a leading provider of these services (around 30% of revenues).
• Sustainability Data and Models (ESG Ratings): Providing data and ratings for environmental, social, and governance factors.
• Private Assets Data and Services: Gradually expanding into private assets, offering data, models, performance analysis, and risk analysis for these markets.

Addressing Systemic Risk and Benefits of Indexing

Fernandez dismisses concerns about systemic risk arising from the sheer number of indexes compared to stocks. He highlights several benefits of index investing:

• Long-Term Investment Horizon: Index investors are inherently long-term, as they remain invested in companies within an index as long as the index exists and is managed against. This contrasts with short-term, active trading strategies.
• Focus on Asset Allocation: With the increasing complexity and number of global assets, index investing frees investors from the day-to-day task of stock and bond selection, allowing them to focus on asset allocation, which accounts for over 90% of portfolio value.
• Liquidity and Transparency: Indexes provide liquid investment vehicles with clear and predictable exposures.

MSCI Stock Performance and Headwinds

MSCI's stock, with a market capitalization of approximately $42 billion, has experienced significant growth since its IPO. However, in the last four years, it has traded sideways or slightly down, with considerable volatility. Fernandez attributes this to two primary headwinds:

1. Active Asset Management Industry Challenges: A significant portion of MSCI's subscription revenue comes from the active asset management industry. This industry has faced challenges due to the rise of indexation and private asset investing, as well as a shift towards concentrated portfolio investing. While active managers typically recover in bull markets, they have not fully rebounded in recent cycles. MSCI is developing new products, such as those for active ETFs, to support this industry.
2. ESG/Sustainability Data and Ratings Pressure: MSCI experienced substantial growth (around 50%) in its ESG offerings a few years ago. However, due to the political climate in the US and re-regulation of ESG criteria in Europe, demand has decreased. While Fernandez expects this to rebound, it has impacted recent stock performance.

MSCI is compensating for these headwinds by focusing on index investing (particularly in this investing), risk management, and private assets, though these have not yet fully offset the previous growth rates.

The ETF Business and Private Markets Opportunity

ETF Business

ETFs are described as an "investment wrapper" or "investment vehicle," similar to mutual funds but trading on an exchange with potential tax advantages. ETFs initially focused on index investing, which has been a major driver of MSCI's revenue. The ETF market is now expanding into active investing, digital currencies, and tokenization of private assets. MSCI sees ETFs as a continued major revenue driver, especially with the growth of "non-market cap exposures" (investment theses on indexes rather than just market exposure) and active ETFs.

Private Markets

The influx of capital into private markets, coupled with a scarcity of benchmarks, presents a tremendous opportunity for MSCI. Institutional asset allocators aim to leverage global economic growth, and while public assets offer transparency and liquidity, private assets often lack these. MSCI is working to bring transparency to private markets by providing data on credit ratings, market risk, underlying holdings, and leverage for private credit, private equity, and private real estate funds. While MSCI does not provide liquidity, it offers valuation services to help investors buy and sell fund units based on estimated portfolio values. This initiative aims to unlock a significant amount of assets for both individual and institutional investors, as most of the global economy resides in private entities.

Currently, MSCI's private asset offerings are primarily data-driven, focusing on portfolio transparency, performance, and risk. They are developing models for capital calls and distributions in private equity and for blending private and public asset portfolios. The creation of benchmarks for private markets is also underway, allowing investors to compare their portfolios against the total market universe.

Climate Change and AI as Transformative Forces

Fernandez identifies Artificial Intelligence (AI) and climate change as the two most significant future transformations in global capital markets. While AI is currently at the forefront, climate change is also poised to have a profound impact. MSCI is developing a wide range of products to help clients navigate climate change, which will create both winners and losers in investment portfolios. These products include:

• Carbon Emission Data: To understand climate change impacts.
• Valuation Models: Assessing asset present values based on different climate change scenarios.
• Risk Assessment: Evaluating portfolio risk associated with climate change.

MSCI's climate-related business experienced rapid growth (100% three years ago, then 50%), now growing at 20%, reflecting a shift in demand from transition risk (net-zero targets) to physical risk, as the direct effects of climate change become more apparent. MSCI is leveraging AI extensively in its climate product development and sees climate change as a significant area for the company's future growth.

Personal Journey: From Nicaragua to Wall Street

Henry Fernandez shares his personal journey, originating from Nicaragua. His upbringing, as the son of a civil servant, was geared towards a career as a civil servant, specifically an economist at the central bank. However, the Nicaraguan Revolution altered his path. He pursued economics and was in a PhD program when he became a political refugee. Facing difficulties securing employment with multilateral organizations due to country quotas, a professor recommended business school. During business school, he discovered Wall Street, fell in love with it, and pursued a career there, which ultimately led him to his current role at MSCI. He expresses gratitude for being "thrown out" of his country for his capitalist views, leading him to the United States, which he considers a "great country" and "the envy of the world."