Passive indices have become subject to particular regulatory scrutiny in the aftermath of the scandal surrounding fraudulent actions connected to the London interbank offered rate (Libor).
Since passive indices are submission-based and require a provider to self-report data to demonstrate performance, they face similar potential conflicts of interest. (Libor desks at several banks have been found both to ‘low ball’ estimates to the benefit of trading counterparties and may have underestimated submissions to exaggerate their creditworthiness.)
For the European Commission, there is no distinction between the types of conflict of interest experienced in banks’ submissions of Libor and those required by index providers, notes Clement Boidard of the Rapporteur Investment Management Steering Committee at the European Securities and Markets Authority (Esma).
He was speaking during a two-day conference on indexation and passive investment in London recently, at a time when Esma is preparing regulation for index funds – including the new generation of smart-beta products – that do not fall under Ucits rules.
New rules would have ramifications for index providers globally, including for investors in Asia, where investment into passive indexing and smart-beta strategies has been gaining traction.
Taiwan’s Labor Pension Fund was an early adopter, replacing as much as $3 billion of its market-cap exposure with a range of strategies including those employing fundamental and minimum volatility weightings.
At the end of last year, State Street Global Advisors reported $47 billion in non-market-cap-weighted indices across 10 strategies in Asia Pacific.
But other investors, including the Hong Kong Jockey Club, have been more circumspect, questioning the complexity and opaqueness of new products’ methodology.
The regulation of smart beta in Europe falls within the wider rules about passive investment. And investors are impatient for greater transparency, according to research presented at the same conference by Frédéric Ducoulombier, professor of finance at Edhec Business School.
Between August and November, Edhec surveyed 109 institutional investors from across Europe, including Europe’s largest pension and reserve funds, insurance firms and their asset management subsidiaries. Some 85% of respondents said transparency is the best way to mitigate conflicts of interest – and only 12% view good index governance as sufficient to deal with these conflicts.
The survey revealed frustration at current levels of transparency in index funds: only 4.6% of respondents were “very satisfied”.
The result was less confidence in new indices, including the wave of smart-beta products that have come to market: 81% said the credibility of reported track records, especially when it came to newer types of index, was undermined by providers’ opacity.
The way forward, investors argue, is for providers to give enough information about methodology, index constituents and where to find the data, so that investors can create back tests to check the numbers. Some 80% of respondents said the way to improve standards was to provide enough evidence for complete replication in this way.
Importantly, this goes much further than the current transparency requirements for index funds within Ucits that would not allow replication.
Interestingly, individuals at the conference reported diverging standards of transparency between providers of equity and bond indices.
John St Hill, responsible for equity and bond management at the UK’s Pension Protection Fund, said equity index providers typically provided necessary data and were clear on methodology. But getting equivalent data from investment banks for bond products was much harder, he noted.
James Duberly, director of pensions investments at the British Broadcasting Corporation, also reported problems with data supplied and clarity over trading costs when he looked at a range of indices in fixed income as part of a quantitative screening process.
The discussion also raised the question of whether opacity was justified on commercial grounds: were providers permitted by commercial agreements with exchanges to disclose all pricing information to users, for example?
Ducoulombier said providers had muddied the debate between identifying required data and supplying it.
But investors were not asking that providers disclose underlying prices for free. They said they were happy to pay for it, but wanted clarity over which data they needed to get hold of and the methodology to apply to it.