A Rise of Passives, a Rise of Scrutiny

FINANCIAL TIMES MONDAY NOVEMBER 18 2013 15 FTfmIndex investing A rise of passives, a rise of scrutiny Overview Providers staunchly defend their products against both regulators and adherents of active management, writes Chris Flood ndex-based investing is expanding rapidly across glo- Ibal 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 recover- ing, 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 gov- erning financial benchmarks. Both the International Organi- zation 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. Nick Lowndes But the industry has found itself under another regulatory spotlight with the European Com- Hartmut Graf, chief executive of adding that retail investors, who will come under more pressure Rob Arnott, chairman of Research mission in September proposing Stoxx, questions whether further typically hold just a small propor- and be replaced by index-based Affiliates. stricter rules for all index provid- regulation is necessary as index- tion of their assets in passive strategies. Ian Ashment, global head of ers following the Libor scandal. based investing has worked well, funds, should embrace indexing A US study published in July structured beta and indexing at Providers of financial indices “without manipulation or distor- as they often lack the resources to demonstrated the potential value UBS Global Asset Management, are furious that their products, tion”. choose the best active managers. of such a shift. Two think-tanks says institutional clients have which are based on verifiable He worries that “over-regula- Repeated studies have demon- based in Maryland found that US been quick to see the benefits that transactions and transparent tion” is likely, driving costs strated that active managers in public employee pension funds alternative indices can offer and methodologies, have been con- higher by requiring more external both equities and bonds on aver- could save $6bn a year in fees and are “far bolder” in making alloca- flated by regulators with the auditing and potentially con- age fail to deliver consistent out- make better returns if they used tions than expected. interbank lending market that straining access to more innova- performance, strengthening the low-cost index funds instead of “Almost all clients want to talk was manipulated by traders for tive products for ordinary inves- case for passive investment strate- employing active managers. about smart beta and how to profit. tors. gies. Active managers look likely to incorporate alternative indexing However, Michel Barnier, Euro- Mr Pettit says index-based Mr Graf says those areas of come under even more pressure into their overall approach, pean Commissioner for financial investing offers “hope for active management that fail to as index-based investing becomes whether as part of a buy and hold services, has made it clear that progress” in financial markets, provide added value for investors increasingly sophisticated, with strategy or for more tactical appli- the proposed rules will “ensure more asset classes being linked to cations,” says Mr Ashment. for the first time that all bench- alternative index strategies, other- Ron Bundy, chief executive of mark providers have to be author- wise known as “smart beta”. Russell’s index business, says ised and supervised”. Contents One of the smart beta pioneers, smart beta indices are a “great Baer Pettit, head of the index Research Affiliates, recently saw complement” to both passive business at MSCI, says regulators Regulation Industry says Brussels’ Smart beta The pros and cons of assets linked to its fundamentally strategies and active manage- are “off-target”, adding that finan- proposals in wake of Libor scandal strategies including low-volatility weighted indices race past the ment. cial indices “have added greatly to are ‘too broad’ Page 16 and fundamental indices Page 20 $100bn milestone to reach $107bn. Smart beta indices can help transparency standards” in capi- “Investors have realised that investors achieve “more precise” tal markets. China Opinions vary over when A Pension fund strategies Where market-cap weighting is not opti- portfolios, he says, allowing them There is no record of any abuse shares will feature in broader Calpers leads, other public plans mal and are interested in viable to increase or shrink their or scandal involving financial equity market indices Page 18 are urged to follow Page 21 [indexing] alternatives to more indices, he adds. costly active management,” says Continued on Page 16 16 FINANCIAL TIMES MONDAY NOVEMBER 18 2013 FINANCIAL TIMES MONDAY NOVEMBER 18 2013 17 Index investing Brussels takes broad brush approach to fix Libor scandal “benchmark” that creates ing says. In contrast, an Regulation issues for index providers. index such as FTSE 100 is Carl Fernandes, a finan- entirely different. Rules would inhibit cial regulation partner at “Not only can trades be references to Linklaters, says: “European made on the FTSE 100 but regulators are trying to the index is composed of countries outside ensure index methodology independently, publicly EU, reports is not too opaque and their quoted assets and the meth- administrators are transpar- odology of the index is also Charlotte Moore ent about where their dis- published,” Mr Lansing cretion lies, and manage says. any conflicts of interest. Mr Redding adds index The European Commission “Any customised index providers are “scratching has reacted to the Libor and will be caught by this regu- their heads trying to under- Euribor scandals by propos- lation.” stand why the regulator Steady as you go: MEP Sharon Bowles has suggested a staged introduction of regulation for ing draft legislation that The universe of product needs to look at such an benchmarks administered outside Europe Epa aims to restore the integrity that will fall under pro- enormous range of indices of these benchmarks. The posed regulation is vast. that are very different to or administered outside proposals and could be how their benchmark corre- broad scope of the propos- Rick Redding, the chief Libor and Euribor”. Europe will not be able to amended. There are encour- sponds to International als, however, has serious executive of the Index Alex Matturri, chief exec- do so unless that country is aging signs that a more Organisation of Securities implications for all index Industry Association, says: utive of S&P Dow Jones deemed equivalent by the rational approach is being Commissions’ standards. providers. “I am not sure that market Indices, says: “We are not European Securities and taken. Then there would be a As well as covering Libor participants and govern- concerned what the regula- Markets Authority.” “In early November,” Mr 30-month period during and Euribor, the proposed ment officials have realised tion would force on index If this legislation were to Redding says, “some mem- which third-country admin- regulations would apply to the current members of providers as we already come into force as it is cur- bers of the European Parlia- istrators could apply for any other index including Institute of Internal Audi- adhere to many of the con- rently written, European ment started to question authorisation. equity stalwarts such as the tors publish around 2m cepts. What we are trying fund managers may well be whether the scope of the While there may be posi- FTSE 100, and indices on indices.” to explain to regulators is restricted in their ability to legislation is too broad, tive signs that cooler heads any other asset class, such Index providers think the the process is not broken, reference an index, depend- whether this is the best are starting to prevail in as fixed income, foreign scope of the legislation is so why fix it?” ing on the location of the approach to the problem the European Commission, exchange or commodities. too broad. Townsend Lans- The so-called third coun- author or administrator. and whether the problem is there are no guarantees They also cover the pleth- ing, head of regulatory try authorisation is also Mr Matturri says that in really as broad as some that a proportionate regula- ora of new, non-traditional, affairs at ETF Securities, causing concern. Mr Fern- the US, for example, there attest.” tory response is the one indices such as fundamen- says: “I think this proposed andes says: “Any fund man- is currently no plan for the There are also proposed that is finally drafted. tal indices or currency- legislation is regulatory ager who wants to reference Securities and Exchange changes to the third- Mr Fernandes says: hedged fixed-income indi- creep. While Libor and the an index which is produced Commission or the Com- country authorisation. Sha- “While it is encouraging to ces. They could even cover FTSE 100 are both indices, modity Futures Trading ron Bowles, the UK Liberal see that there is now some an index that an institu- there are considerable dif- Commission to regulate Democrat MEP and chair- momentum in the Econ tional investor asked a fund ferences between these two ‘What we are trying index providers, so it is woman of the parliament’s committee to narrow the manager to develop as a entities.” to explain to unclear how that would be economic and monetary scope of the legislation and bespoke product.

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