Few investment tools have had such implicit, long-lasting trust heaped upon them as the humble, well-worn index. Forming part of the fund management architectural design process, indices serve as a vital instrument with which to measure performance, select stocks and build portfolios, and with which to model active investment strategies.
Elsewhere, they form the backbone of packaged products, such as exchange traded funds (ETFs) and tracker-funds, providing investors with exposure to markets they could not otherwise access. More broadly, they serve as a barometer by which investors, fiscal policy-makers, politicians and economists gauge the mood of the market and the economy at large, and upon which they make fundamental, long-lasting decisions.
Evidently, the burden of trust placed upon indices, the providers of indices and index-based products, is heavy to say the least. And this trust grows daily: as many investors have become disillusioned with active managers who have failed to earn their hefty fees, they are turning instead to ‘passive’ index-based investments promising lower-costs and more reliable returns. As such, it is an ever-competitive marketplace in which new, innovative indices and index-based investment products are launched on a weekly basis.
But it this trust well-placed? Are indices, so frequently thought of as dispassionate barometers of market activity, all they appear to be? This is increasingly in doubt. In fact, there is a growing body of evidence to suggest that the very word ‘index’, in so much as it confers a highly credible degree of scientific rigour, actually obscures a vast and varying range of practices that are subjective, lacking in standardisation, and misunderstood by the investment community.
The bare necessities
Ideally, the primary purpose of any index is to accurately represent the theme that it claims to represent: but successfully achieving this end is an extraordinarily technology-intensive process. Indices, after all, are comprised entirely of data. The first requirement of any major index provider, therefore, is to capture, aggregate, cleanse and calculate vast volumes of data from multiple sources on a daily basis.
Take, for example, HSBC, which produces a number of ‘cap-weighted’ equities indices – indices in which each company’s value within the index is equal to its market capitalisation as a percentage of the index’s overall value. Each day, HSBC captures data relating to multiple data points on 98.5% of the world’s stocks by market cap – equal to 55,000 securities. In itself, this is no small task. Once this data is captured, however, it must then be cleansed regularly to ensure its quality – a job that, when performed properly, is often highly manual.
But the data cannot only be clean; it must also offer historical depth in order to ensure quantitative strategies can be back-tested and modelled. This can only be properly performed on a robust but flexible, internally developed technology platform, by which the provider will also calculate the index on a daily – if not intraday – basis. Only once these components are in place can the index provider set about constructing an index that is rigorously researched, correctly weighted, fully liquid and based on consistent, systematic rules. As such, index creation of this kind is a detailed, painstaking process.
When HSBC set about building its Global Climate Change Benchmark Index, for example, Kevin Bourne, global head of eEquities at HSBC Global Banking & Markets and his team examined each of the 55,000 securities on which the bank collects data, checking the performance of each stock, quarter by quarter, back to 2004.
“Building the index involved industrial number crunching. From start to finish it took us nearly seven months and many, many man-hours,” says Mr Bourne.
High-end variance
Here, at what is undoubtedly the most skilled and disciplined end of the index-creation market, the barrier to entry – in terms of the ongoing investment in technology, expertise and time required to build and maintain a range of robust, representative and accurate indices – is extremely high.
Only a handful of organisations can be found in this bracket, including US-based providers Russell Investment Group, Standard & Poor’s (S&P), MSCI Barra, Dow Jones, UK-based FTSE, and a small number of investment banks.
Even at the premium end of the market, however, doubts are growing as to the degree of clarity and consistency that characterises well-established and commonly referenced indices. Among the most compelling research in this space is that conducted by Dr Craig Iraelsen, an associate professor at Brigham Young University in Utah. Published by specialist publication IndexUniverse.com in 2007, Dr Israelsen’s research finds that the performance of well-established indices measuring the performance of US equities within the same sector bracket frequently show substantial differentiation.
Taking performance data provided by US-based Morningstar, an investment research organisation (that also has an index business), on a number of indices offered by Dow Jones, MSCI, Russell, S&P, Reuters-owned Lipper and Morningstar itself, Dr Israelsen found that over the past 10 years the average annual one-year spread between best and worst performing large-cap growth index equalled a chunky 990 basis points.
The most extreme individual example of this differentiation can be found in the year 2000, when the Lipper Mid-Cap Growth Index gave a one-year return of -2.1%, while MSCI US Mid-Cap Growth Index came in at -26.3%, representing a differentiation of no fewer than 4200 basis points.
Evidence of such wild differentiation suggests that the construction methodologies used by the major index providers vary considerably, says Dr Israelsen. “It is clear that there is a lack of uniformity in both the definition and the measurement of these theoretically distinct equity markets,” he writes. This finding has severe implications for the way in which fund managers measure and compare performance: indeed, to a very large extent, proof of performance will be dependent on the performance benchmark index of choice.
Transparency and independence
If the methodologies behind the industry’s most respectable, technologically-rigorous indices appear to be less than consistent, they are at least – broadly speaking – independent and for the most part transparent. Investors wishing to understand, for example, the way in which S&P constructs its indices need simply visit the company’s website. This cannot be said for all major indices, particularly those built by some investment banks and brokerages.
For the latter, indices have become an important business line during the past two years. But in many, although not all instances, says Ted Niggli, executive director at MSCI Barra, the rules of these indices are not transparent or shown to be systematic.
“The selection criteria for the securities in the index are based on their internal research – and they don’t volunteer it. As an investor you don’t know what their analysis was and how they came up with this basket,” says Mr Niggli.
This is not the case for all banks, some of whom will reveal their research and methodology. But they are not compelled to do so and it is often incumbent upon the client to ask the right questions.
This is especially true where the associated issue of index independence is concerned. Here, the independence of the brokers, both as creators of indices and sellers of index-based products, is sometimes doubtful. “That’s where some investors might have the right to question some of the brokers’ indices,” says Mr Niggli.
Investment banks such as Barclays Capital, Merrill Lynch and HSBC Global Banking & Markets build indices within the research department, the independence of which is dictated by strict regulatory rules. But many banks do not make the distinction, however, building their indices within the trading or structuring environments. Stephan Flagel is managing director and head of UK-based data provider Markit’s new index division, having joined from Barclays Capital where he was chief operating officer for global research. He believes the brokers face a potential conflict of interest in this regard.
In some smaller firms, The Banker has been informed, this conflict of interests can lead to dubious trading activity, in which traders front-run changes to the index – that is, trade ahead on the knowledge that constituent stocks will change at a pre-determined date and time.
Meanwhile, the independence of indices operated further down the food chain – within smaller, less technologically capable brokerages and sometimes insurance firms – is difficult to ensure, the constituents and rules of such indices often being dictated by product sales teams. Dow Jones, for example, has actively refused to build indices in such instances, where the purpose and integrity of the prospective index is questionable. Undoubtedly, other providers will be willing to pick up such business however.
From passive to active
Many of the concerns about indices, however, are not to do with consistency and independence but relate to the rapid growth and changing nature of the business. With few unique openings now available, some index providers are now entering niche terrains, fast-developing and pushing out to market highly innovative index products against which they hope to quickly gather assets. Exchange traded funds, an index-linked basket of stocks or bonds traded on exchange, are a salient case in point. The investment vehicle has enjoyed phenomenal growth during the past ten years, with the value of assets linked to ETFs in the US growing from just over $69bn in 2000 to $613bn in 2007, according to IndexUniverse.com.
While it is widely agreed that ETFs are a positive development, allowing investors to gain cheap and flexible exposure to markets from which they were previously excluded, the super-competitive nature of the marketplace has led some index providers to push the boundaries of traditional indexing. Fundamental indexation, by which indices are weighted not by market-cap but by other ‘fundamentals’ such as company dividends or even sales, has become a point of particular controversy and, for critics of the strategy, a source of some concern.
Increasingly, indices weighted on this basis, and the ETF products that track them, are composed of a small sub-set of stocks, the selection of which is tilted in order to drive market-beating performance. Jim Wiandt, editor of a stable of specialist index publications, including IndexUniverse.com, disputes the theory promoted by advocates of fundamental-weighted indices that it is possible to pursue this strategy and enjoy comparable risk to that experienced with traditional benchmark or ‘beta’ indices. “I think you have to realise that you are making a bet against the market,” says Mr Wiandt.
Neil Michael, head of quantitative strategies at SPA ETF, a new London-based provider of ETFs, is quite explicit on the nature of such index products: “They are rules-based but the active index, on which SPA ETF has launched ETF products, is effectively an active portfolio.” SPA ETF expects to outperform the standard benchmark indices by an ambitious 10%. Mr Michael concedes, however, that investors take on additional risk when buying such products. “You don’t get those kinds of returns without volatility,” he says.
In this strategy, index providers, as creators of quantitative alpha-driven indices, are effectively operating as outsourced active portfolio managers. For many, this is a far cry from indices in their traditional and best-understood sense. SPA ETF says its approach, and that of its index-provider US-based MarketGrader, is highly transparent. Mr Wiandt says, however, that there are some examples where active-index providers are effectively running a ‘Black-box’ methodology under which they reserve the right to change the criteria at will. Investors may “have no idea” regarding the rules and criteria that govern the product’s performance, meaning the risk is consequently uncertain. “You don’t know what’s going on and your risk could be wide open in relation to outperformance of the target index,” says Mr Wiandt.
Though many ETF and index-based products do perform well, the complexity of the indexing industry means that many investors, institutional and retail alike, may not understand the nature of the products that they are buying. Neil Edelstein, vice-president of product solutions at data specialist GoldenSource, has worked at both S&P and a company that specialised in rebalancing indices. He is wary of both the opacity and complexity that has come to characterise index-creation, an industry that has seen “too little regulation too late,” he says.
Regulatory imperative
Despite the increasingly pivotal role they play in driving active, alpha-seeking investment strategies, none of the index providers approached by The Banker are directly regulated by a financial regulator.
The Banker also approached a number of global regulators, including the UK FSA, the Japanese FSA, the SEC, and the Australian Securities Exchange regarding this issue. None prescribe specific rules for index creation, index categorisation or index products. The latter are broadly treated as managed funds or managed investment schemes, and are regulated accordingly. There appears to be no direct regulation, or intention to directly regulate in future, index creation or the categorisation of indices, however.
Under some circumstances – particularly in less mature markets – the local regulator will defer oversight of major indices to the licensed exchanges that publish them. This is the case in South Africa, for example, where the Financial Services Board – which until very recently only allowed licensed exchanges to build indices – stipulates that all indices are investigated and approved by the Johannesburg Stock Exchange.
In other jurisdictions there is evidently confusion regarding the scope of oversight: when approached on the issue, the UK FSA directed The Banker to the London Stock Exchange, which subsequently redirected the enquiry back to FTSE.
It is the US, however, where one of the most fertile landscapes for ETFs and quantitatively driven index products can be found. Despite presiding over this hyperactive market, however, the SEC was entirely unable to assist The Banker with its enquiries.
In any event, says David Fry, founder of specialist publication ETF Digest, and a former broker and investment advisor, the US index market is now too expansive, diverse and complex to be properly regulated. “No matter what they tell you, none of these regulators or exchanges has the resources to investigate all these indices,” says Mr Fry.
Nonetheless, Mr Wiandt believes that the SEC has now woken up to the reality that the products for which the regulatory body has granted approval are not in fact based on passive beta indices – as it had assumed. “It seemed to me that they were blind-sided by them, and by the time they fully recognised what was going on, products that were effectively active management had already hit the market disguised as indexes,” says Mr Wiandt.
Perversely, the SEC is presently taking steps to expedite ETF filings. In this respect, says Mr Fry, the situation is becoming more complex.
Borrowed credibility
Few would argue that the regulators should necessarily scrutinise the way in which indices – which are not, after all, securities – are constructed. Many market participants feel that there is, however, vast scope to improve the transparency surrounding the research, methods and rules by which indices are constructed and subsequently operated; to provide greater clarity regarding the intended purpose of an index and its associated risk; and to ensure greater stringency surrounding the independence of indices, particularly when built by organisations that are also product providers and engage in trading activities.
Perhaps not surprisingly, the major index providers deny that there is any need to regulate their activities. “There is a self-regulatory aspect in that we are fully transparent,” says Markit’s Mr Flagel. This being the case, it would surely serve the interests of the major index providers to call for greater clarity and disclosure surrounding index creation. The explosion of proprietary indices and niche index providers has created a lucrative outsourcing market for the top-tier index players boasting expansive IT infrastructures – particularly in the case of outsourced index calculation which is an ever-growing business line. For this reason, it might not necessarily be in their interests to promote regulatory activity that could potentially shrink their client base – although they would be sure to comply with any new rules.
In acting as a calculation agent, however, the top-tier index providers frequently lend a high degree of credibility to indices, the associated risk of which remains opaque.
As such, the practice has served to further confuse the index creation landscape, and to enable a chain of deferred responsibility. “There is pressure to pass the buck in terms of due diligence and responsibility: the index creator and the product pusher are all sort of in bed together,” says Mr Fry.
Rampant competition between index providers, both great and small, will do little to improve this situation. Improved clarity, standardisation, and greater disclosure, would be in the best interests of both the investor and the market.
