A rise of passives, a rise of scrutiny

November 15, 2013 6:26 pm

A rise of passives, a rise of scrutiny

By Chris Flood

Index-based investing is expanding rapidly across global financial markets in a shift that offers big rewards to providers of popular benchmarks. It is also, however, attracting growing scrutiny from regulators. The most visible evidence for the rise of index-based investing comes from growth in the exchange traded funds industry which now commands assets of $2.3tn. Trillions of dollars more are held in index-based portfolios by pension and sovereign wealth funds and other institutional investors.Indices are also widely used for pricing in both structured products, where issuance is recovering, and also in the derivatives markets, where the outstanding value of contracts contines to rise.

The expanding role of indices in financial markets has led regulators to re-examine the rules governing financial benchmarks.

Both the International Organization of Securities Commissions and the European Securities and Markets Authority have published guidelines intended to strength investor protection through improved standards of transparency and disclosures.

Providers of financial indices felt that their own standards and practices already went beyond these guidelines and banded together in 2012 to create an association to better respond to regulators’ concerns.

But the industry has found itself under another regulatory spotlight with the European Commission in September proposing stricter rules for all index providers following the Libor scandal.

Providers of financial indices are furious that their products, which are based on verifiable transactions and transparent methodologies, have been conflated by regulators with the interbank lending market that was manipulated by traders for profit.

However, Michel Barnier, European Commissioner for financial services, has made it clear that the proposed rules will “ensure for the first time that all benchmark providers have to be authorised and supervised”.

 

Baer Pettit, head of the index business at MSCI, says regulators are “off-target”, adding that financial indices “have added greatly to transparency standards” in capital markets.

There is no record of any abuse or scandal involving financial indices, he adds.

Hartmut Graf, chief executive of Stoxx, questions whether further regulation is necessary as index-based investing has worked well, “without manipulation or distortion”.

He worries that “over-regulation” is likely, driving costs higher by requiring more external auditing and potentially constraining access to more innovative products for ordinary investors.

Mr Pettit says index-based investing offers “hope for progress” in financial markets, adding that retail investors, who typically hold just a small proportion of their assets in passive funds, should embrace indexing as they often lack the resources to choose the best active managers.

Repeated studies have demonstrated that active managers in both equities and bonds on average fail to deliver consistent outperformance, strengthening the case for passive investment strategies.

Mr Graf says those areas of active management that fail to provide added value for investors will come under more pressure and be replaced by index-based strategies.

A US study published in July demonstrated the potential value of such a shift. Two think-tanks based in Maryland found that US public employee pension funds could save $6bn a year in fees and make better returns if they used low-cost index funds instead of employing active managers.

Active managers look likely to come under even more pressure as index-based investing becomes increasingly sophisticated, with more asset classes being linked toalternative index strategies, otherwise known as “smart beta”.

One of the smart beta pioneers, Research Affiliates, recently saw assets linked to its fundamentally weighted indices race past the $100bn milestone to reach $107bn.

“Investors have realised that market-cap weighting is not optimal and are interested in viable [indexing] alternatives to more costly active management,” says Rob Arnott, chairman of Research Affiliates.

Ian Ashment, global head of structured beta and indexing at UBS Global Asset Management, says institutional clients have been quick to see the benefits that alternative indices can offer and are “far bolder” in making allocations than expected.

“Almost all clients want to talk about smart beta and how to incorporate alternative indexing into their overall approach, whether as part of a buy and hold strategy or for more tactical applications,” says Mr Ashment.

Ron Bundy, chief executive of Russell’s index business, says smart beta indices are a “great complement” to both passive strategies and active management.

Smart beta indices can help investors achieve “more precise” exposures to particular drivers of risk and return.

Mr Bundy says conversations between Russell and its investors frequently focus on questions about portfolio construction and how traditional market cap-weighted indices, smart beta strategies and active management can best be combined to suit a client.

Alex Matturri, chief executive of S&P Dow Jones Indices, believes smart beta has “a place” in portfolios but he cautions that it cannot replace the role of cap- weighted indices as the primary benchmarks for clients’ assets and as the most widely accepted performance benchmark for different asset classes.

Ursula Marchioni, a director in the European investment strategy team at iShares, the ETF arm of BlackRock, says investors are becoming more “active with their passive” as they blend index-linked investment vehicles and different types of betas in their portfolios.

She says the trend for blending index-based vehicles and strategies is also increasing the need for investors to perform thorough due diligence.

BlackRock describes due diligence for index investing as a three-step process which involves selecting the right benchmark, choosing the most appropriate investment vehicle and finding the best portfolio manager.

“Index investing will continue to grow and play a key role in financial markets over the next 10 years and beyond. Investors who understand beta in depth and the evolution of index investing will be best positioned to harvest the benefits and avoid any potential pitfalls,” says Ms Marchioni.

Her view is echoed by Mr Graf at Stoxx, who says growing numbers of investors realise that going passive can bring huge benefits, not just in terms of lower costs.

He notes that concerns about risks became much more prominent in the aftermath of the financial crisis. The crisis prompted many investors to seek a different balance between risks and returns, requiring a more granular analysis of the drivers of their portfolios. Mr Graf says financial indices can help investors position their exposures much more precisely, making it easier to put together the appropriate building blocks to achieve their desired portfolio.

But he also says it is important for investors to strike a balance between cutting-edge research and understanding their objectives, adding that index providers usually have different discussions when dealing with sophisticated institutions and retail clients.

Mr Pettit at MSCI says strategy indices provide a “codification” of factors such as value, size and momentum that have been identified as drivers of risk and return in portfolios.

However, he says employing these factors also requires a rigorous analytical framework, otherwise it is easy to become distracted by noise or data sampling.

“One can debate the nuances or technical issues relating to factor indices but the bigger point is that they offer new ways of expressing a range of investment views,” says Mr Pettit, adding that MSCI’s discussions with institutional investors such as pension funds, sovereign wealth funds and banks focus on these drivers of risks and returns as well as overall portfolio risks.

Thus, the indexing industry appears set for further growth, promising a bright future for providers that can successfully deliver reliable benchmarks to satisfy both regulators and investors