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 prod- ucts, 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 regula- tors 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 transpar- ency 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 asso- ciation to better respond to regu-

lators’ 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. Libor is a survey of the viewed by the EU. affairs committee, has sug- address the third-country The proposed regulations different interbank lending regulators is the While the legislation pro- gested a staged introduction authorisation, it’s impossi- would apply to three rates – it is not an index process is not posals, put forward in Sep- of regulation for bench- ble to say where the groups: administrators, con- that can be traded. “It is the tember, are causing concern marks administered outside debate will end up and how tributors and users of inability to trade Libor that broken so why fix it’ among the index industry, Europe. influential the committee’s benchmarks. But it is the has made it more prone it is important to keep in Initially, administrators views will finally prove broad definition of a to manipulation,” Mr Lans- mind that they are only would have to explain only to be.”

Index providers A rise of passives, a rise of scrutiny By benchmarked ETF assets*($bn) S&P Dow Jones 645.6 MSCI 328.0 Continued from Page 15 ent asset classes. the best portfolio manager. many investors to seek a “codification” of factors Ursula Marchioni, a direc- “Index investing will con- different balance between such as value, size and Barclays 193.3 exposures to particular driv- tor in the European invest- tinue to grow and play a risks and returns, requiring momentum that have been FTSE 187.1 ers of risk and return. ment strategy team at key role in financial mar- a more granular analysis of identified as drivers of risk Mr Bundy says conversa- iShares, the ETF arm of kets over the next 10 years the drivers of their portfo- and return in portfolios. Russell 125.5 tions between Russell and BlackRock, says investors and beyond. Investors who lios. Mr Graf says financial However, he says employ- Stoxx 112.5 its investors frequently are becoming more “active understand beta in depth indices can help investors ing these factors also focus on questions about with their passive” as they and the evolution of index position their exposures requires a rigorous analyti- CRSP 92.7 portfolio construction and blend index-linked invest- investing will be best posi- much more precisely, mak- cal framework, otherwise it Nasdaq 87.0 how traditional market cap- ment vehicles and different tioned to harvest the bene- ing it easier to put together is easy to become distracted weighted indices, smart types of betas in their port- fits and avoid any potential the appropriate building by noise or data sampling. LBMA 76.8 beta strategies and active folios. pitfalls,” says Ms Mar- blocks to achieve their “One can debate the Markit 68.8 management can best be She says the trend for chioni. desired portfolio. nuances or technical issues End Oct, (funds and products) combined to suit a client. blending index-based vehi- Her view is echoed by Mr But he also says it is relating to factor indices * Alex Matturri, chief exec- cles and strategies is also Graf at Stoxx, who says important for investors to but the bigger point is that Source: ETFGI utive of S&P Dow Jones increasing the need for growing numbers of inves- strike a balance between they offer new ways of Indices, believes smart beta investors to perform thor- tors realise that going pas- cutting-edge research and expressing a range of overall portfolio risks. has “a place” in portfolios ough due diligence. sive can bring huge bene- understanding their objec- investment views,” says Mr Thus, the indexing indus- but he cautions that it can- BlackRock describes due fits, not just in terms of tives, adding that index pro- Pettit, adding that MSCI’s try appears set for further not replace the role of cap- diligence for index invest- lower costs. viders usually have differ- discussions with institu- growth, promising a bright weighted indices as the pri- ing as a three-step process He notes that concerns ent discussions when deal- tional investors such as future for providers that mary benchmarks for cli- which involves selecting the about risks became much ing with sophisticated insti- pension funds, sovereign can successfully deliver reli- ents’ assets and as the most right benchmark, choosing more prominent in the tutions and retail clients. wealth funds and banks able benchmarks to satisfy widely accepted perform- the most appropriate invest- aftermath of the financial Mr Pettit at MSCI says focus on these drivers of both regulators and inves- ance benchmark for differ- ment vehicle and finding crisis. The crisis prompted strategy indices provide a risks and returns as well as tors. 18 FINANCIAL TIMES MONDAY NOVEMBER 18 2013 Index investing

China’s A shares poised to go global

$4tn, the China A shares the consultation did not requires a one-month wait, Pause for reflection: QFII and RQFII pro- Renminbi market could substantially imply that A shares had although weekly repatria- investors monitor stock grammes. alter the global investing achieved emerging markets tion is possible with dedi- prices at a Shanghai On the QFII side, the Opinions vary landscape if it were to be status in terms of market cated open-ended China securities company overall quota was lifted in on when market incorporated into various accessibility criteria. funds. In the RQFII scheme, Bloomberg April 2012 from $30bn to broader indices, industry Mr Chia counts the quota daily repatriation is $80bn, then was almost dou- will become participants say. system and limited capital allowed. bled in July to US$150bn. completely open, Chia Chin-Ping, who is mobility as the biggest rea- For asset managers, it is The foreign ownership limit head of equity research for sons holding back A shares crucial that these two par- has been increased from writes Kylie Wong Asia Pacific at MSCI, says from going global. ticular issues are addressed, 20-30 per cent and the appli- A shares could account for To access China’s capital says Kevin Hardy, head of cation process for a QFII up to 13 per cent of the market, foreign investors beta strategies for Asia licence has been stream- China has made significant MSCI Emerging Markets must rely on the qualified Pacific and country head lined. strides in opening up its index if China were to be foreign institutional inves- for Singapore at BlackRock. On the RQFII side, not capital markets to foreign “completely opened up”. tor or the renminbi-quali- “There are a few other only has the overall quota investors, but several key Together with the existing fied foreign institutional things as well but these two been significantly increased challenges need to be weighting of 16.8 per cent, investor schemes. are very critical for the from RMB70bn to addressed before the main- China as a whole could rep- Mr Chia says that, while indexing space because if RMB270bn, but the pro- land equity market can fea- resent close to 30 per cent the overall quota of the we can’t freely access or gramme has also been ture in broader equity of the index. schemes is “fairly signifi- have a limited amount we expanded beyond Hong benchmark indices. However, Mr Chia cant”, the issue is more can access, there’s no way Kong to Taiwan, London Mainland-listed equities stresses that would be about the alignment of that we can track an index,” he and Singapore. traded in the renminbi, also under a “very hypothetical” quota with the size of says. Nonetheless, Ms Pak known as A shares, are cur- scenario, as there are still a investors. While Mr Chia and Mr acknowledges that it all rently excluded from global number of hurdles that “We’ve seen some sover- Hardy are optimistic that boils down to whether the indices as they are not need to be overcome, such eign wealth funds getting the issues will eventually key issues of quotas and freely accessible by the glo- as quota allocation, capital quotas beyond $1.5bn but be resolved, they stop short capital mobility will be bal investing public. The mobility and taxation on they are a lot larger than of giving a timeframe for resolved for China A shares existing China representa- capital gains. that, $1.5bn is probably still when they believe the to be included in the tion within those indices is When MSCI announced in a small amount,” he says. inclusion could become a broader indices. largely via H shares, which June that it had started “More importantly, the reality. In the meantime, says Mr are Chinese securities listed reviewing A shares for majority of the QFII inves- Meanwhile, Jessie Pak, Chia. index providers and in Hong Kong. potential inclusion in the tors, who are sizeable inves- managing director for Asia asset managers should With a sizeable market MSCI Emerging Markets tors and managers, are still at FTSE Group, says she maintain active communi- capitalisation of just under index, it emphasised that waiting for more quotas to predicts China A shares cation with regulators as be awarded, so that process will be able to migrate to well as step up efforts to needs to take place.” global indices as soon as educate investors about So far, only three QFII “a few years’ time”. China investing, because Contributors participants – the Hong Ms Pak says China’s participating in the market Kong Monetary Authority, opening up of its capital will take time and it is Chris Flood Andrew Baxter Norway’s Norges Bank and market in recent years has uncertain precisely when A Reporter, FTfm Production Singapore’s Temasek Full- gathered pace and that the shares will be included in erton Alpha – have been developments are “getting global indices. Owen Walker Andy Mears granted allotments above more and more positive”. ‘If we can’t freely “Of course, we are not Managing editor, Ignites Pictures $1bn. She cites the expansion of access, or have a going to rush through the Capital mobility restric- the RQFII scheme as an process but, if tomorrow, Kylie Wong For advertising contact tions are also a major example. limited amount we the Chinese government Associate editor, Ignites Steven Canfield on +44 impediment to China’s Indeed, the past 18 can access, there’s decides to abolish some of Asia (0) 20 7873 4802; email inclusion in global indices. months saw a number of these restrictions to make [email protected] or In terms of repatriation of positive regulatory moves no way we can things easier, there’s no Charlotte Moore your usual Financial Times capital, the procedure is by Beijing in an attempt to reason we should not see Freelance writer representative. particularly stringent under further open up the A track an index’ the inclusion happen,” he the QFII scheme, which shares market under the says. FINANCIAL TIMES MONDAY NOVEMBER 18 2013 19 20 FINANCIAL TIMES MONDAY NOVEMBER 18 2013 Index investing Take care when choosing alternative route

Since the 1970s financial well-priced alternative mar- metric other than market known as low volatility defensive nature or high Smart beta academics have pointed out ket indices. Advances in capitalisation. One tech- indices and their propo- dividend income, which fur- the flaws in market capitali- technology have made it nique is to use another eco- nents say that on a histori- ther increases demand and Charlotte Moore sation-weighted equity indi- much easier for fund man- nomic metric such as cash cal basis and in risk-ad- pushes up the price. looks at what ces. There is plenty of com- agement companies to offer flow per share, dividend justed terms, these strate- Alan Miller, chief invest- pelling research illustrating a wide array of different income or book value. gies do better than the mar- ment officer of SCM Pri- fundamental and a variety of different index products, often These are known as funda- ket over the long term. vate, says: “Many of the low volatility index approaches to indexing that referred to as smart beta mental indices. While there is a very stocks that make up a mini- promise to give better products. The second category aims broad range of indices avail- mum volatility index cur- strategies offer returns with lower risk. These can be viewed in to control some of the risks able, it is easier to find rently have the worst com- Until recently, however, it two broad categories. There associated with equity products for some strategies bination, namely low inher- has been difficult for inves- are those that aim to refor- investing, principally the than others. And investors ent growth with a very tors to find a wide range of mulate an index using a volatility risk. These are need to find those strategies demanding valuation.” which suit them best while It is worth noting that, avoiding the pitfalls. recently, low volatility indi- Phil Tindall, senior ces have underperformed investment consultant at market-cap weighted indi- Towers Watson, says: “The ces. But that is to be best types of strategies are expected: minimum volatil- those that are more trans- ity indices underperform parent, straightforward and during bull markets and easy to understand – and outperform during bear which avoid proprietary markets. For example, dur- processes such as optimisa- ing the tech bubble in the tion.” late 1990s traditional indi- The decision to buy an ces outperformed minimum alternative index strategy volatility indices. means that the asset owner Imke Hollander, head of is taking much of the investment strategy responsibility for perform- research at Blue Sky Group, ance on to their own shoul- says: “Minimum volatility ders rather than transfer- should not perform well in ring that task to an active this type of environment. manager. But when there is stress in “It’s really important for the market, such as during them to understand the the financial crisis, they characteristics: the simpler perform very well. It’s the product, the easier it is important to look at per- to know what you are buy- formance over the cycle.” ing,” says Mr Tindall. It is also important to have realistic performance ‘The simpler the expectations. “These strate- product, the easier gies should be used over the long term and the investor it is to know what must accept that there will you are buying’ be periods when market-cap indices will perform better,” Phil Tindall, adds Mr Tindall. Towers Watson While there is a broad range of alternative index products available, low vol- While minimum volatility atility indices have been the indices may not seem as most popular, garnering the good value at the moment, greatest asset flow. fundamental strategies The appeal of a low vola- have appealing characteris- tility index is straightfor- tics. Mr Giles says: “The ward: the returns on equi- prices on these indices have ties are appealing yet their not suffered in the same volatility is off-putting. Low way because of their intrin- volatility indices allow sic focus on fundamental investors to access those value.” returns while keeping a lid Mr Tindall concurs: “A on this particular risk. fundamentally-weighted But there are a number of index is attractive because factors that investors it’s a relatively straightfor- should be aware of before ward product and the taking the plunge into mini- design means they exploit mum volatility indices. The well-known investment recent popularity of this characteristics such as alternative index makes it value.” This is because fun- harder to find fair value. damental indices create a Tim Giles, partner at Aon bias towards stocks trading Hewitt, says: “We have seen at a low price relative to a lot of funds flowing into their fundamentals. minimum volatility Whichever alternative recently, which has pushed investment is chosen, it is up the prices of this product vital that investors have – making it look less their eyes wide open. Jeff favourable over the medi- Molitor, Vanguard’s chief um-term.” investment officer Europe, Investors should also be says: “Investors must know aware that the stocks that what they are buying, and are often included in low recognise they are taking a volatility indices tend to be position that might not concentrated in certain sec- work in all market environ- tors such as consumer sta- ments, even if the historic ples and utilities. These data are compelling. They stocks appeal to other should also take a look at investors because of their the returns after cost.” FINANCIAL TIMES MONDAY NOVEMBER 18 2013 21 Index investing If you cannot beat them, track them

ment, the endorsement of are making more and more tility index fund would ager risk and they are around the world. “Initially Strategies index funds is widely seen use of are strategies called favour stocks that provide cheaper than active funds, we saw more interest from as highly significant. Calp- smart beta or alternatively more predictable returns, but [investors] are still European pension plans. Where Calpers of ers had already switched its weighted indices. These are and therefore the fund’s making decisions.” But we were surprised in $1.6bn defined contribution indices that are constructed performance overall will be Such strategies often cost 2012 by how fast US plans the US leads, plans to passive manage- in a way that allow the less choppy. more than traditional mar- started to adopt these others may follow, ment earlier this year and a investor to take an active “They fit nicely between ket-cap-weighted index indexes,” says Diana Tidd, slow march towards passive position on how assets with an active and a pure pas- funds because there is usu- head of the MSCI index says Owen Walker funds is now expected in its certain characteristics will sive approach,” says Simon ally more trading involved. business in the Americas. defined benefit plans. perform, but without hav- Midgen, head of index funds But they are cheaper than “Europe is ahead still, but Pension funds on both sides Other public pension ing to choose the individual strategy at Legal & General active management and the rate of adoption in the of the Atlantic have plans are being urged to fol- securities. Investment Management. have been increasingly US has surprised us,” she increasingly been adopting low Calpers’ lead. A damn- For example, a low-vola- “We are removing the man- adopted by pension plans adds. the same mantra when it ing report from the Mary- comes to the investment land Public Policy Institute markets: if you cannot beat and Maryland Tax Educa- them, track them. tion Foundation released A continuous trickle of this summer argued US research papers shows that public pension plans could the majority of active man- wipe out $80bn in unfunded agers consistently fail to liabilities by simply switch- beat index-tracking funds ing from active manage- when their higher fees are ment to passive. taken into account. And An analysis of the 46 pension funds are taking state pension funds for notice. which the report’s authors In September, the Califor- were able to get data nia Public Employees’ showed there was a direct Retirement System (Calp- correlation between higher ers) – the second-largest US management charges and pension plan and sixth larg- lower returns, net of fees. est in the world, according The 10 pension plans pay- to Towers Watson – made ing the highest fund man- an announcement with lit- agement fees – which aver- tle fanfare that many aged 60 basis points – observers have claimed is a achieved average returns of boon for passive fund man- 0.34 per cent. For 10 states agement and an alarm bell paying the lowest fees – for poor performing active which averaged 22 bps – the managers. average return was 2.38 per In a document entitled cent. Calpers Investment Beliefs, The paper argued that if the $260bn pension plan all the 46 funds switched to outlined a set of guiding passive management, they principles that would form would save a combined the basis of all future $6bn a year in fees and investment strategy deci- have better or at least com- sions. Number seven on the parable performance. list was a commitment to UK pension funds, mean- “take risk only when we while, attracted criticism in have a strong belief we will October from Prince be rewarded for it”. Charles for “becoming As part of this statement, increasingly unfit for pur- the Calpers board said it pose”, while former City would use index strategies minister Paul Myners where it lacked conviction accused the industry of or demonstrable evidence “turning gold into lead”. At that it could add value the same time, UK pension through active manage- funds were accused by ment. It said it would also investment manager Ever- use passive indices as a ref- core Pan-Asset of wasting erence to measure whether more than £6bn a year active managers were per- investing in active funds forming well and providing rather than in better per- value for their higher fees. forming passive equiva- For a pension fund with lents. 64 per cent of its portfolio While Calpers may be one dedicated to active manage- of the largest plans to have explicitly outlined the case for passive management, others have already set about increasing their pas- sive exposure and making use of different strategies. “An increasing number of pension funds in the US as well as the UK are looking to focus active management in areas of greatest opportu- nity while utilising index- based strategies in areas where it can complement, ultimately providing them with greater control over their investment out- comes,” says Jamie Forbes, director at Russell Indexes in Europe. Jamie Forbes: funds want One area of passive man- more control over outcomes agement that pension funds