Self-Indexing—Cause For Cheer Or Concern?
[This article previously appeared on our sister site, IndexUniverse.eu .]
ETFs were originally developed to track the indices that active managers found so hard to beat. Now, in a drive to cut costs in an increasingly competitive market, some ETF managers are seeking to “self-index”, creating and calculating their own benchmarks. Should investors in passive funds welcome this development or be wary?
US fund manager Guggenheim recently filed paperwork with the national regulator, the Securities and Exchange Commission (SEC), to develop and launch its own indices. BlackRock, parent company of iShares, the world’s largest issuer of ETFs, did the same in August . Other US ETF issuers that use proprietary indices include WisdomTree, Van Eck, Claymore, HealthShares and IndexIQ.
However, combining ETF management and index provision in the United States is legally problematic. Section 17 of the 1940 Investment Company Act (“40 Act”), which governs the large majority of US investment funds, places tight restrictions on investment companies’ dealings with affiliated parties.
Previous applications to self-index were only approved if the ETF managers concerned could persuade the regulator that they would not contravene section 17, said Kathleen Moriarty, partner at Katten Muchin Rosenman, who advised Wisdomtree and IndexIQ in their dealings with the SEC. In practice, this meant that ETF managers had to outsource the calculation role to a third party or, for example, physically separate themselves from any affiliated index provider.
In its August application, which is still under review at the SEC, BlackRock says it wishes to internalise all index-related functions, including “compilation, maintenance, calculation, dissemination and reconstitution activities”.
“In any such application to manage an index in-house, the SEC will need to be convinced that the index is being calculated free and clear of the ETF, and that the ETF manager doesn’t know what the index provider is doing,” said Moriarty in a telephone interview with IndexUniverse.eu.
According to one index industry veteran, who wished to remain anonymous, the SEC has been strict in its past interpretation of the 40 Act’s affiliated party clause. For example, the source said, when index provider IIC (now part of Markit), operator of the iBoxx and iTraxx indices, bought the $ InvesTop and the $ HYTop corporate bond benchmarks from Goldman Sachs in 2006, renaming them the iBoxx $ Liquid Investment Grade index and the iBoxx $ Liquid High Yield index, Barclays, which at the time owned more than 5% of IIC, was forced to give up its shares’ voting rights. This was because Barclays, via its fund management subsidiary BGI, owned iShares, which in turn ran ETFs tracking these indices (notably LQD, the iShares $ Investment Grade Corporate Bond Fund), said the source.
The SEC originally had concerns about possible index manipulation even when an ETF provider and firm providing the ETF’s index weren’t connected, said Katten Muchin Rosenman’s Moriarty, who also advised State Street on its 1993 application to launch the SPDR S'P 500 ETF Trust (NYSE Arca:SPY), now the world’s largest exchange-traded fund. In the case of SPY, said Moriarty, it proved relatively easy to convince regulators that the S'P 500, as a long-standing and widely followed benchmark, would not be subject to potentially malign influence from those managing tracker funds. “However, you can see the potential concern if an ETF manager is launching its own, new index, particularly in less liquid areas of the market,” she added.
In Europe, the rules currently governing the indices tracked by passive investment funds are focused on the suitability of the underlying index as an investment benchmark, not on preventing transactions with related parties. UCITS, the standard for European funds on offer to retail investors, specifies that an index-replicating fund should use a benchmark that is “adequate” for the market to which it refers, “sufficiently diversified” and “transparent”. There are currently no restrictions on who may act as index provider.
However, a tightening of European regulatory guidelines for index-tracking funds appears to be on the way. ESMA, Europe’s securities market regulator, devoted a lengthy section of its recent ETF discussion paper to the topic of strategy indices. ESMA’s proposed policy changes include a requirement to publish the full index calculation methodology for such indices, to disclose all index constituents (albeit with a lag) and the publication by UCITS managers of a clearly documented conflicts of interest policy, given, says ESMA, that “in many cases the manager/investment manager of the UCITS, the counterparty to the swap and the index provider are part of the same group.”
Concerns have also been prompted, according to a November Financial Times article by Steve Johnson, by the combination of derivatives and proprietary indices in certain UCITS funds to generate investment exposures that would not be permissible under European regulations if obtained directly.
ESMA is due to publish its proposed new guidelines for ETFs and structured UCITS later this month.
In practice, however, said Konrad Sippel, head of global product development at index firm Stoxx, it’s the norm in Europe’s ETF market to use third parties for benchmark provision. By contrast, said Sippel, in Europe’s retail-focused certificates market, the indices tracked are often proprietary to the issuing banks. Certificates are a bank-issued debt instrument, usually based on an index of shares or bonds.
Even if a bank or asset management firm develops the investment idea underlying a potential new index for an ETF, a third-party index provider will usually be invited to manage and calculate it, said Gareth Parker, European director of research and design at Russell Indexes.
There are potential conflicts of interest if the duties of fund manager and index provider are merged, say representatives of index firms.
“I’ve heard someone say that having the index maintained by the asset manager is a bit like having the referee of a football match on the payroll of one of the teams,” said Dimitris Melas, head of index research at MSCI. “From a governance perspective there are questions in combining these roles.”
“We believe that the independence of the index provider is important, since this eliminates any potential conflicts of interests that may arise if an index is managed in-house. Such conflicts of interest may include the embedding of poorly disclosed fees in the index, how index constituents are priced, and the methodology used in selecting them,” said Stoxx’s Sippel.
However, one European issuer that manages some ETFs tracking in-house benchmarks defended the practice, arguing that more stringent requirements are already in place for such funds.
“The regulator in Luxembourg, where our ETFs are domiciled, requires us to fill in an eligibility form with a long checklist of criteria if we want to use a proprietary index,” said Manooj Mistry, head of db x-trackers UK. “Disclosure requirements also differ:if we’re using a third-party index we typically give it a one-page description in our fund prospectus, whereas if the index is proprietary the description is usually several pages long. Our index unit, DBIQ, is part of our research team and is separated by a Chinese wall from the business unit.”
The growing trend towards self-indexing is motivated primarily by business concerns, say many fund providers. In an increasingly competitive market index licensing costs threaten to absorb an increasing share of fund fees.
“There’s a natural commercial tension between fund managers and index firms, since benchmark providers form an effective monopoly,” said Deutsche Bank’s Mistry. “They have the index brand and we as product providers have to pay whatever fees are necessary to track their benchmarks. Some index firms can also be inflexible in terms of data, stating that providers can’t disclose index components on their websites in real time, even though we may be required to do so by stock exchange rules.”
Tom Rampulla, managing director of Vanguard’s UK operation, made a similar observation.
“Index firms have gained a lot of market power over the years with the increasing popularity of passive investing,” said Rampulla. “Some of the licensing fees are pretty expensive, especially on ETFs, and are problematic if you’re trying to get the annual cost of a product down to single digits in basis points terms.”
BlackRock’s US application to develop in-house indices might therefore be interpreted as a warning to index firms over their pricing policies, said one ETF market observer, who wished to remain anonymous. It’s still unlikely in practice, though, said the observer, that proprietary indices would be used for any but a small group of funds using so-called “smart beta” strategies, involving semi-active management and frequent benchmark rebalancing.
In summary, the trend towards increasing in-house provision by asset managers of their passive funds' benchmarks promises lower costs to investors, but also raises questions over conflicts of interest and governance. Regulators’ stance on the separation of duties between index provider and asset manager remains rather unclear and is inconsistent between the US and Europe. While an understandable development on commercial grounds, it’s an open question whether the growing self-indexing movement is cause for investors’ cheer or concern.
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