Recent announcements delaying or cancelling the periodic rebalancing of various indices – or the decision not to delay – have raised some comment in the market regarding the use of discretion (or “expert judgement”) to set aside the usual processes outlined in index providers’ index rules documents.
Each index provider will have considered the issues in detail and come to what it feels is the appropriate decision. But the more one considers the ramifications, the more complex the issues are. There is value in therefore having a wider debate: while historically index providers have been seen as merely providing “part of the plumbing” of the investment world, the fallout from these recent decisions makes it clear that their role is far more important, in creating very significant flows in and out of various assets – or of stopping the flow of assets, as happened as a result of these rebalance cancellations.
The background is simple. Index providers generally maintain well-written, comprehensive rules / methodologies, that attempt of explain how the index will change, automatically, in response to events such as corporate actions, and how the indices will be regularly reassessed, or rebalanced, to ensure they remain an accurate barometer of whatever “economic interest” they are measuring – top 100 companies, highest dividend-paying companies etc. These rules however generally contain an exception rule that allows the index providers to set aside the rules when the provider considers that necessary to maintain index integrity, or accuracy, or some other description essentially meaning “when something unforeseen has happened.”
Indices are used for a number of reasons, including general benchmarking of active management performance, but the group most impacted by the periodic rebalancing of indices are those running and investing in “passive” – i.e. index-based – investment products such as ETFs and mutual funds. They are using indices in order to benefit from a rigorous, rules-following process that does not incorporate discretion or the associated costs of discretion.
Setting aside the rules is clearly an active decision that leads to an impact indistinguishable from active management – a clear statement that the index provider believes the markets are not properly pricing companies. It could also be considered to result in the indices – and index-based products – moving away from their underlying “economic interest”, i.e. not representing it accurately.
Index providers are clearly conflicted, in having paying index licensees, as well as a broader group of stakeholders who are not necessarily licensees, but are still dependent on, or acting based on the indices.
As a result and because of the profound implications these decisions will have, best practice in the governance of indices should be a key topic to discuss now, despite the current challenging environment.
I think the following key points have arisen.
- Was this an appropriate use of the exception rules? These were originally created to deal with closed markets, unavailable data etc, not just “difficult” markets. Clearly the specifics of the current situation were to some extent unforeseen, but similar levels of market turbulence have been seen in the past.
- Was the market really not providing good pricing, or difficult trading conditions? Initial analysis suggests volumes have generally risen, allowing easier trading, although spreads have widened. With the exception of a few “circuit breaker” events, markets have remained open and trading. It’s also worth noting that most index-related trading occurs in closing market auctions, when everyone achieves the same trading price as the index.
- If the current environment is indeed one in which rebalancing isn’t appropriate, given prior experience, it is a shame that this was not already addressed within rules, so that discretion was not needed. So, how should index providers adapt their rules so that future similar environments don’t require the use of discretion. What quantitative metrics could be used to define such environments?
- If we are in or approaching an environment where perhaps rebalances might need to be pulled, the market is most likely best served by this being considered and carried out in an organised manner, by all index providers, so that correlations, tracking errors etc remain in phase. What would be the right trigger (presumably quantitative?) for a discussion, and the right forum for that discussion? Would it be the Index Industry Association, the regulators, or some other forum?
- Governance over the use of discretion, and transparency, are key components of the various index regulations. For example, index providers are required to have oversight of their index management decisions that is independent of their management and operations, so that decisions can be assessed and shown to be in compliance with rules and regulatory obligations. “Material changes” to index methodologies should be consulted on in advance.`
Therefore, as much clarity as possible from index providers on their governance processes is likely to be worthwhile, perhaps in the following areas:
- Demonstrating that governance procedures have been carefully followed and that full oversight took place, i.e. index providers could visibly demonstrate that the conflicts of interest between their different users are managed.
- Giving consideration to making it clear that setting aside index rebalance events to be considered a “material change” that should be preceded by an appropriate consultation with stakeholders, even if that would require a compressed timeframe.
- Giving clear “forward guidance” as to their intentions with regards to future reviews, or the criteria under which decisions would be made.
In the absence of this, regulators may look at extending their powers, which allow them to require fully independent oversight, including regulatory involvement, of those providing “critical” benchmarks (a defined regulatory term which does not currently include the S&P 500 or FTSE 100), either by requiring further independence in oversight of all index providers, or perhaps by deeming some systematically-important indices to be “critical” whether or not they meet the strict quantitative requirements of the current “critical” definition. A subsidiary question would be the extent to which a non-EU index provider would feel its administration of its non-EU indices should be impacted by EU regulation, simply because those indices happen to be used within the EU.
To reiterate, these are not easy questions. But for that reason a debate is likely to be beneficial to the whole index investing industry.
 S&P, for example, has now instituted a consultation on how it should handle the fallout of its decision to delay its index rebalances – by continuing with them in a month’s time, or by formally cancelling the current rebalance and proceeding as normal in June with the next rebalance.