Index transparency A European Perspective

Transcription

1 Index transparency A European Perspective Regulatory developments and investor requirements By Frédéric Ducoulombier Director, EDHEC Risk Institute Asia 8 May/June 2013

2 Indices play a crucial role in investment management, from strategic asset allocation to risk analysis and performance measurement. They serve as references for passive and active investment products and mandates, whereby an asset manager attempts to replicate index performance or deliver performance that is superior to that of the index. While index provision is generally not a regulated activity, regulators have for long imposed qualitative restrictions on indices that could be used by retail funds. However, these requirements were relatively high-level. It is only recently, against the backdrop of the rapid growth and diversification of indexing products, and in the shadow cast by integrity issues with the oil price and interbank rate benchmarks, that indices have received closer scrutiny and the question of imposing higher standards of methodological quality, governance and transparency upon indices has been discussed. In this article, we review recent regulatory developments and ongoing discussions related to indexing with particular emphasis on transparency, which has taken on critical importance with the emergence of new forms of indices. UCITS REQUIREMENTS AS THE BEACON OF TRANSPARENCY The Product Directive (2001/108/EC), which increased the investment freedoms of European retail funds (known as Undertakings for Collective Investment in Transferable Securities, hereafter UCITS), introduced the first reference to financial indices in UCITS regulation. The directive relaxed risk-spreading rules to allow for the replication of (apparently poorly diversified) well-known and recognised indices. It also permitted outright investment in financial derivatives and, recognising financial indices as an acceptable underlying for these derivatives, it created the possibility of synthetic replication. The directive authorised the replication of indices recognised by the competent authorities as being sufficiently diversified, representing adequate benchmarks for the market to which they refer and being published in an appropriate manner. These requirements were first clarified by the Eligible Assets Directive (2007/16/EC). To be considered an adequate benchmark, an index must measure the performance of a representative group of underlyings in a relevant and appropriate way and be revised or rebalanced periodically, according to publicly available criteria, to continue to reflect the markets to which it refers. Transparency requirements with respect to publication are described as the wide and timely provision of material information on matters such as index calculation, rebalancing methodologies or index changes. In July 2012, after one year of work and consultations that had initially focused on the exchange-traded fund (ETF) market, the European Securities and Markets Authority (ESMA) established new transparency requirements for index-tracking UCITS and updated the eligibility criteria of financial indices. These rules (ESMA/2012/832EN) are applicable to newly created funds since 17 February 2013 other UCITS have one year to comply. With respect to transparency, ESMA clarified that each index should have a clear, single objective and that the universe of the index s components and the basis on which components are selected should be clear. ESMA went further and prohibited the use of indices that do not disclose their full calculation methodology or fail to publish their constituents together with their respective weightings. The regulator also required this information to be accessible easily and on a complimentary basis to investors and prospective investors. ESMA also prohibited investment in indices whose methodologies are not based on a set of predetermined rules and objective criteria, or which permit the so-called backfilling of data. One of the key objectives evident in ESMA s new requirements is the regulator s desire to restrict UCITS choice of indices to those that are built and managed in a systematic manner and for which index providers make available sufficient information to the public to allow for independent replication on a non-commercial basis, a precondition for informed investment decisions (ESMA underlines that detailed information on index constituents and on calculation and rebalancing methodologies must be available and that the parameters or elements needed for replication should not be omitted). The requirements thus go beyond what would be needed for a high-level understanding of the objective, methodology and historical performance of an index, which would suffice for investor orientation and a basic screening of indices. They enable interested parties to audit the track record of indices, observe how discretion is exercised and conduct performance and risk analyses to assess the relevance and suitability of each index against the specific goals of investors. ESMA s decision increases investor protection and fosters information-based competition in a significant segment of the indexing business. EDHEC-Risk Institute has constantly underlined the need to promote a horizontal approach to regulation, ensuring coherent treatment of economically equivalent products, irrespective of their legal form or channel of distribution, lest arbitrage opportunities be created or exacerbated. To foster a level playing field and a high level of consumer protection across the European investment industry, we have thus recommended transposing the advances pioneered by ESMA in the UCITS space to other investment products and solutions. To promote progress in indexing practices in other jurisdictions, we have endorsed the new ESMA framework as a global beacon of transparency. Non-UCITS indexing products that are close substitutes at least from a financial risk perspective to products structured as UCITS should therefore be subject May/June

3 to the same high transparency standards. This concerns both fund and non-fund products, whether they are exchange-traded or distributed by their manufacturers or intermediaries. In the retail market, all investment funds, insurance-based investment products, retail structured securities and structured term deposits (collectively known as Packaged Retail Investment Products) and not simply UCITS should be subjected to high and uniform levels of transparency. As far as listed products are concerned, exchange-traded notes should not be associated with lower transparency, when it comes to their underlying indices, than ETFs. While it is understandable that the regulator has wished to address the protection of retail clients first, there is no obvious reason to deny professional investors other than UCITS the transparency advances introduced by ESMA for UCITS. Indeed, the bulk of institutional investors manage assets to meet the liabilities of what indices and benchmarks, and three related international consultations have taken place in recent months a consultation on indices led by the European Commission and consultations on benchmark setting processes led by the International Organisation of Securities Commissions (IOSCO) and ESMA and the European Banking Authority (EBA). These consultations were preceded by domestic reviews into the interbank interest rate benchmark scandals and work by IOSCO on oil price benchmarks. Both types of benchmark were found to suffer from severe problems with data collection, whereby reporting entities had both the capacity to influence benchmark levels and the economic incentives to do so, and providers had inappropriate processes to prevent, detect or remedy misbehaviour. The loose link between submissions and transaction data and the inadequacy of processes for controlling data quality and integrity facilitated Regulators have a fresh mandate to regulate benchmarks and indices since the recent LIBOR scandals are ultimately retail clients. Most of them, notably tier-2 and tier-3 institutional investors, should be expected to be at a disadvantage relative to the asset management companies offering UCITS when it comes to procuring the information they need to perform their due diligence. This is all the more important in the context of investment management mandates, which are set up bilaterally and may be based on indices for which no information is disclosed publicly. Asymmetry of information between the investor and the party providing the indexing solution is thus particularly strong and justifies pre-contractual corrective disclosures that will allow the investor to conduct due diligence on the quality, integrity and suitability of the underlying index. To enhance investor protection and competition in the indexing market and reduce opportunities for regulatory arbitrage heightened by the new transparency requirements applicable to UCITS, one possibility is to continue to proceed piecewise and coordinate the transposition of these advances into regulatory updates affecting relevant products and financial institutions, accepting the likelihood of blind spots and implementation delays. Another possibility, which is currently being debated, is to consider regulating the provision of indices and benchmarks directly. THE TREATMENT OF TRANSPARENCY IN RECENT REGULATORY CONSULTATIONS The scandals that have recently surrounded the interbank interest rate benchmarks such as LIBOR have given regulators a fresh mandate to review the provision of misconduct. Meanwhile, the conflicts of interest faced by providers in both markets undermined governance. The LIBOR scandal and perceived problems with oil benchmarks focused the attention of regulators and commentators upon the specific weaknesses of benchmarks that are based on surveys and over-the-counter market data and, in particular, their unique susceptibility to conflicts of interest at the level of the reporting entities. This starting point may not have been an ideal one from which to approach the regulation of indices and benchmarks in general and those using transaction data from regulated markets in particular. As a result, the recent regulatory consultations, while fixated upon the issue of conflicts of interest in general, largely fail to recognise the diverse conflicts inherent in the index provision industry. Moreover, they view transparency primarily through the prism of conflicts of interest and as a mitigating factor to be used when the index methodology is understood to be susceptible to particular conflicts of interest. While these consultations include statements that point to future measures to increase transparency, on a par with those recently ushered in by ESMA for UCITS, they also associate transparency with the words adequate or appropriate. They also venture that transparency should be approached in the context of each index s control framework and governance arrangements, and that it might be considered sufficient if interested parties are able to understand the the index s objective and its methodology. Such ideas may pave the way for a decrease in index transparency, relative to the advances recently introduced by ESMA, and could result in a framework that promotes a false sense of safety with respects of conflicts 10 May/June 2013

4 of interest and, more importantly, falls short of providing users with the information required to discharge their due diligence responsibilities. In our contributions to these consultations, we have therefore underlined that conflicts of interest exist across the index industry and could not be addressed sufficiently by improved governance mechanisms. We also explained that transparency was not only the best tool to mitigate these conflicts but also an essential prerequisite for informed investment and risk management by index users. CONFLICTS OF INTEREST EXIST ACROSS THE INDEX PROVISION INDUSTRY The integrity of an index is at risk whenever its provider is engaged in or is influenced, for example by virtue of its ownership or business dealings, by entities that engage in activities whose success is affected by the composition or performance of the index. For example, conflicts of interest arise between index provision and origination and listing activities when the latter can be facilitated or made more profitable by the inclusion of an issuer s securities in an index. We also explained that providers could be tempted to use the leeway created by discretion in an index s ground rules to alter its composition in directions that they may consider favourable for the index s future commercial development for example, by favouring assets or sectors that appear to display positive momentum, although these may not coincide with the interests of index users interested in a systematic management approach and the stability of risk factors. In this respect, we underlined that linking index licensing fees to the amount of assets tracking the index, for example at a fund management firm paying those licensing fees, creates conflicts of interest comparable to those faced by entities that track in-house indices (selfindexers) 1. This is of particular concern when indices aim to achieve a given risk/return objective ( strategy indices ) rather than representing a given market or segment ( market indices ). The latter are marketed primarily on the basis of their representativeness, and providers are relatively indifferent to their performance. By contrast, strategy indices are typically advertised on the basis of their performance, including their outperformance vis-à-vis market indices. Performance-based competition and the indexation of revenues to assets under management could tempt providers to use discretion to select or weight components with a view to improving the performance of their indices. Such a temptation would, of course, be magnified when there is perfect hindsight about the subsequent performance of components, that is when an historical track record is simulated. When track records rely to any material extent on back-tested data which is notably the case with strategy indices there are risks that the index methodology may have been optimised on the basis of this data (in sample) with little or no regard for the stability or persistence of its performance beyond this period (out of sample). There are also risks that hindsight biases (for example, choosing from survivors, using restated/backfilled data, picking winners or shunning losers) entered the simulation, whether or not there was an intention to mislead. The realistic simulation of a track record is timeconsuming and requires the use of point-in-time data, as well as the simulation of index committee decisions that attempts to control for hindsight biases whenever discretion is exercised. This is true whether the index methodology is systematic or not. If the methodology is systematic, its application outside of the back-tested period may yield very different results and its actual risk-return profile may bear little resemblance to that displayed during the back-tested period if no concern for out-of-sample stability was shown in design, if backtested data was contaminated by hindsight, or if the implementation of the methodology is not consistent across periods. If the methodology is not systematic, little consistency or stability should be expected in the first place. This is recognised by index users since 74 percent of participants in the EDHEC-Risk European Index Survey 2011 report the avoidance of discretionary decisions as important in index construction. TRANSPARENCY IS THE BEST MITIGATOR OF CONFLICTS OF INTEREST The recent regulatory consultations discuss various internal controls and procedures (from information barriers to internal audits by an independent compliance function) to minimise the likelihood that conflicts of interest will affect integrity. They also mention the use of external, non-market-based mechanisms such as oversight committees, external audits or the self-certification of compliance with codes of ethics or industry standards. While strict internal controls and procedures can reduce the risks of abuse, we consider that non-marketbased governance mechanisms are at best of third-order importance and at worst counterproductive. This is due to the moral hazard and adverse selection phenomena that can result from the false sense of safety that they promote. For example, oversight committees may not be exempt from conflicts of interest themselves and are susceptible to capture by management or other powerful interests. Altogether, such mechanisms, even when they impose a strong fiduciary duty on their participants, have proven incapable of preventing major scandals in the past and little should be expected from their reform. As Jonathan Macey, a professor at Yale Law School, has remarked: Enron itself met or exceeded the higher standards ostensibly promulgated to prevent future Enrons. For these reasons, external, non-market-based governance mechanisms should not be seen as alternatives to full transparency. Transparency is the most powerful May/June

5 mitigator of conflicts of interest since it allows for the independent and multilateral verification of track records and puts the exercise of discretion under public scrutiny. Hence, we strongly caution against any temptation to trade lower levels of transparency for stronger governance mechanisms. We are therefore particularly concerned by the position of the ESMA Securities and Markets Stakeholder Group in its recent advice to ESMA (ESMA/2013/ SMSG/03), since the Stakeholder Group not only makes the assumption that governance and transparency are substitutable, but also presents governance as the high road and transparency as a fallback solution enabling low-cost external monitoring in the absence of sound governance mechanisms. This is at odds with evidence showing that market efficiency and integrity are directly related to the quantity and quality of the information available and not to the goodwill of market participants. BEYOND CONFLICTS OF INTEREST: WHY TRANSPARENCY MATTERS In light of the growing importance of indices in investment management and the emergence of new forms of indices, we have repeatedly called for transparency to be provided by index providers or to be imposed by regulators, in case of the failure of self-regulation. By transparency, we mean the availability of clear summary information disclosing an index s objectives and its key construction principles, of complete information on the index construction and calculation methodology, and of historical data on constituents and weights. Such information is required to allow investors to screen indices against their stated investment objectives and constraints, to calculate track records independently, both in terms of risks and performance, to gauge the systematic character of methodologies and understand how discretion is exercised, and to perform advanced quantitative analyses to assess indices relevance and suitability. While this is important for market indices, it is all the more so for strategy indices. Indeed, while such indices can provide investors with improved risk/reward profiles or other benefits, they bring distinct risks of their own, notably the risk of periodic underperformance vis-à-vis market indices, which to this date remain the primary benchmarks. Furthermore, while there are often several providers offering indices with comparable objectives, closer inspection reveals a wide diversity of methodologies and therefore model risks. To make informed choices, investors need to be able to understand the objectives and underlying conceptual assumptions of these strategies and to conduct thorough quantitative due diligence to assess their specific risks and potential benefits. Such analyses must be based on track records that can be verified to represent the systematic implementation of transparent methodologies to point-in-time data. HOW TRANSPARENT ARE INDICES CURRENTLY? Indices are typically marketed on their transparency and systematic nature, and users see these as the defining properties of indices. Often, however, the pronouncements of index providers do not reconcile with the experience of users. Published methodologies typically lack the transparency required for replication. The IOSCO consultation report notes that the majority of Benchmarks ( ) published their Methodologies but did not always provide enough detailed information to allow users to recreate Benchmark outputs. Likewise, in its response to the ESMA/EBA consultation, the European Fund and Asset Management Association explains that even in the case of market indices, asset managers do not have all the data necessary to fully verify the construction or the accuracy of a benchmark. In the same context, the European Federation of Financial Services Users complains about the near impossibility for retail clients to even access the track records of most major indices because these are not published and freely accessible. These observations are consistent with our own findings. We recently studied 50 market and strategy equity indices to gauge the current degree of transparency and discretion in the index provision industry. In this exercise, we looked at the availability of a high-level description of index objectives and construction principles, assessed the level of detail and discretion in the published methodology, searched for information about back-tested performance and surveyed the ease and cost of access to current and historical index constituents. What emerged was that: (i) methodologies, as described in index ground rules, typically left considerable explicit or implicit room for discretion at multiple levels; (ii) only minimal disclosures were made with regards to the methodologies used for back-tests and, when information could be obtained, it showed significant potential for upwardly-biased performance; (iii) beyond obtaining a list of current constituents, limited information was available at no cost and the costs of acquiring the data required to conduct risk and performance analyses on an index were typically non-trivial (up to 12,000 in one case). While the above underlines the importance of due diligence and paints a negative picture of data availability, it is also relevant to mention that licensing terms typically restrict data use and hamper the performance of analyses or the distribution of their results, for example by requiring prior approval from the index provider. This is despite a policy whereby the index firm typically waives all responsibility if its data are subsequently found to be inaccurate or incomplete. Such restrictions prevent the provision of research and analysis, including academic research, on indices. In the area of strategy indices, there is an abundance of publications but a dearth of relevant research as index promoters author articles that cannot be challenged. 12 May/June 2013

6 RECOMMENDATIONS ON TRANSPARENCY To promote fair competition and a high level of investor protection in the indexing industry without creating barriers to innovation, we consider it key to focus regulation on high standards of transparency. These will not only reduce the potential for misconduct, but also allow investors and other interested parties to gain access to the information required to promote the adequate use of existing products. In turn, this should further innovation in the marketplace. To enable index users to perform a basic level of due diligence and to allow them to orient themselves, index providers should be required, on a complimentary basis, to disclose clearly the objectives of each of their indices along with the detailed metrics that allow for an assessment of the extent to which those stated objectives have been achieved. If several objectives exist, a clear hierarchy should also be provided. Whenever an index provider wishes to market an index based on its track record, the firm should provide full and complimentary transparency on the index s methodology, along with historical information on its values, constituents and weights, as well as documentation describing the basis for and justification of each discretionary decision and change of methodology. This is to enable the independent replication of the index on a non-commercial basis so that interested parties can verify the integrity and robustness of the advertised track record and to conduct additional due diligences as they see fit. Furthermore, regulators should ensure that all interested parties, including other index providers, enjoy the right to use this data freely, including for the purposes of research, index evaluation and performance comparisons. This will not only allow asset managers and end-investors to perform their due diligence at minimal cost, but also foster public debate on the strengths, weaknesses, benefits and risks of indices. In turn, this will create the conditions for a genuinely efficient index market. Providing the public with the information required to independently replicate an index for evaluation or research purposes should not be misrepresented as denying index providers the right to protect and enforce their intellectual property rights. There are legal as well as contractual tools (for example, licenses) to defend index providers against the unauthorised use of their methodologies and data (not to mention the natural protections afforded by the added value, for example the brand or services, that index providers provide to the lawful users of their products). We also note that the transparency required for the non-commercial replication of indices can accommodate important time lags in the release of the underlying data, thus greatly reducing opportunities for free-riding and front-running, which third parties could otherwise engage in at the expense of index users. Opacity typically increases the scope for conflicts of interest to play out as abuse and, worse, practically denies the public the ability to assess the relevance and suitability of indices and to manage their risks properly. Opacity should therefore not be tolerated by regulators as a blanket protection against intellectual property infringements or, in the context of indexing, presented as a way of protecting the interests of investors. Endnotes and References [1] It would thus be dangerous for regulators to condone a distinction between self-indexers and self-styled independent index providers, as this would mislead users into believing that the latter are exposed to a materially lower risk of manipulation and reduce users incentives to perform effective due diligences on the integrity of their indices. In turn, this could exacerbate adverse selection and moral hazard phenomena. Likewise, the expression independent index provider should either be banned or reserved to index providers whose ownership and control structures and other business operations do not create obvious internal or external conflicts of interest. The Journal of Indexes Europe is the premier source for financial index research, news and data. Written by and for industry experts and financial practitioners, it is the book of record for the index industry. Browse content online at JOURNAL OF INDEXES EUROPE PRINT SUBSCRIPTIONS ONLINE AT: May/June