INDEX TRANSPARENCY: Transparent guidance

The use of simulated track records and vague language around methodology is heralding calls for more transparency in the smart beta market. But, discovers Nicholas Pratt, there are different views on how this should be achieved.

The European Securities and Markets Authority (ESMA) published guidelines on exchange-traded funds (ETFs) and other Ucits issues in 2012 and part of this addressed the required level of transparency in a financial index. According to the guidelines, a Ucits fund should not invest in financial indices which do not disclose full calculation methodology that would enable investors to replicate the index themselves. Furthermore, this information should be easily accessible and free of charge. 

Over two years later, the issue of transparency and related regulations has divided the market, especially in the nascent area of smart beta indexes. One of the most vehement proponents of greater transparency is Edhec-Risk Institute (ERI), the France-based academic body that has also entered the index market with its own “scientific beta” index. According to Frédéric Ducoulombier, director of ERI Asia, ESMA’s guidelines have yielded limited progress.

He cites the imperfect application and narrow interpretation of the rules by index providers and a failure to disclose methodologies, especially in the smart beta space where, he says, “some providers refer to proprietary models and data and use vague language”. 

Ducoulombier is also concerned that ESMA’s attempts to introduce more transparency could be undermined by the Principles on Financial Benchmarks devised by the International Organisation of Securities Commissions (IOSCO) which, due to successful lobbying from the index providers, ensures continued opacity in the industry because it only requires that they make available “summary information and key features”.

Europe is at a crossroads, says Ducoulombier. A draft regulation is currently being discussed by the European Parliament and while the chair of the Parliament’s economic and monetary affairs committee, Sharon Bowles, has openly called for greater transparency, if this draft was to be based on IOSCO rather than ESMA rules, it would represent “an important step backward on the road to transparency”.

In particular is the issue of simulated track records employed by some smart beta indices. 

Ducoulombier says: “There should be sufficient transparency to verify that the track record of an index corresponds to the systematic application of a clearly defined methodology, which is a necessary first step in due diligence.” Equipped with the information required, would-be index users could understand the sources of performance and risk characteristics of indices, assess their relevance and suitability, and detect any fabrication or gross manipulation, Ducoulombier says.

Without this transparency investors are left to focus on the only definite information available: cost. “It is rather worrying to note the discussion surrounding these indices – purported to outperform cap-weighted indices by 200 or 400 bps/year – is more focused on costs of 3bps or 6bps than on the value of the concepts that have been implemented and on the measurement of the robustness of track records.”

He says the situation is one of “economic adverse selection”, where investors are unable to differentiate good from bad, and they take the risk of being guided by prices “steered by those who have done the least in terms of constructing a smart beta offering, or who resorted to data and model mining to easily display attractive performance without ensuring robustness”.

Ducoulombier wants more regulation and regulators to ensure there is non-discriminatory access to the detailed methodologies and historical composition of indices, along with the right to analyse data and publish results. Others want a balance between regulation and market forces.

“We have always believed in the principle of transparency,” says Michael Larsen, global head of strategic partnerships at Research Affiliates, provider of the Research Affiliates Fundamental Index, one of the oldest smart beta indices in the market. 

“We have a US patent in place which results in disclosure of the methodology and FTSE, our main partner, has made a statement of support for transparency as embodied in the IOSCO principles. The FTSE RAFI rulebook for equities provides a clear understanding of how the index is constructed.”

Index providers have exploited technology to achieve the benefits of active management but in a more transparent way and within a traditional passive construct, one that reduces the cost of due diligence and investment monitoring for investors. 

Therefore, it follows that truly smart beta indices offer transparency as a key element of their value proposition, Larsen says. However the growth of interest in smart beta and the development of fundamental indices and the technology that enables it, has brought in several new entrants, some of which are less transparent than others.  

“It is important to draw a line between the indices that are proprietary in nature and more active in make-up and those that are more passive in nature and should be transparent. Investors in passive solutions have certain expectations which should be met,” Larsen says.

It is also important to draw a line between what is truly smart beta and what is active management joining it. The problem, says Larsen, is when there is more opaqueness than necessary. 

“There is a tendency to overcomplicate things and a natural temptation to equate complexity and opaqueness with the idea of a better solution.”

Ultimately, market forces and the performance of portfolios will sort genuine indices from the bandwagon passengers, he says. Regulation around transparency should be a balance between mandating certain aspects, but also leaving market forces or market discipline to manage other aspects.“ESMA and IOSCO are both getting to places that are balanced,” Larsen adds.

The biggest call for transparency at Lyxor has been clients not regulators, says Raphael Dieterlen, head of ETF & index investments. Prior to ESMA’s 2012 rules, most smart beta strategies were either run by active managers, or were indexes developed by investment banks not necessarily calculated with the highest standards of transparency of the large index providers, says Dieterlen.

The smart beta market has matured quickly in the last couple of years. On one side are active managers using smart beta techniques in portfolio construction and giving general principles on investment methodology plus discretionary views, and on the other hand are ETF or index replication experts that are promoting smart beta strategies in their own products. 

The Lyxor SmartIX Equal-Risk-Contribution Index Series launched in 2011 and calculated by FTSE, dedicated to large institutional investors, is designed to be replicated by third-party asset managers. 

“There is a clear methodology and transparency around the daily composition and daily forecast,” says Dieterlen. “There is the same level of transparency as a flat market-cap index.”

Dieterlen says there should be no concern that excessive transparency could compromise the proprietary qualities of a smart beta index. “The more transparency, the better. If I did not understand the index methodology, I would not invest.”

Greater transparency would help investors with due diligence, an aspect that ESMA has been keen to promote but which is far from straightforward. According to Dieterlen, the due diligence process for smart beta indices should include these issues: Does your strategy give you the capacity to invest large portfolios? Is it liquid? Does the client know the drivers of performance in the index and the risk factors?

“These properties can be quite tricky determine with a smart beta index,” says Dieterlen. For example, if there are capacity constraints, a portfolio can end up being non-investable for some institutional investors. Also, investors have to decide whether an index is active or passive. 

“The investor should choose an asset manager who is able to provide the necessary information or reporting on the drivers of performance.” 

Dieterlen shares the concerns about simulated track records. “Every track record looks fine so it is a bit of a worry if these indices have been built just to look good in a historical context and are not robust enough to perform well in the future. 

“If you understand the methodology and the strategy, you will know how the track record compares to the future performance.” However, he believes it is down to asset managers to select the right index. He says ESMA’s guidelines are very helpful, though he does not expect any further guidance in the near future.

©2014 funds europe



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