Index Committee Or Index Rules?

April 26, 2012

A second argument for committee intervention is the introduction of "common sense"; in other words, an assertion that rules, however well-constructed, are liable to produce unwanted results, especially when faced with extraordinary market circumstances. The argument is also based on a premise that information may become available that was not anticipated or explicitly planned for by those compiling the index rules. A purely rules-based model may, for example, select a company for inclusion in an index while it is in the process of being acquired by a non-listed entity. If the offer were to be successful, the company would need to be excluded from the index again. Most investors would agree that the inclusion of a company in an index in such circumstances makes limited sense. However, this would again equate to an active decision on behalf of the index committee. Index inclusion would be dependent on a committee's view of the likely success of a takeover bid, a decision that would almost certainly have to be based on the actual terms of the takeover bid. While rules-based indices can anticipate such cases of corporate activity, by definition there will always be some information that has not been applied in the index rulebook that may be available to a committee. One thing the rules-based index would guarantee, however, is that users of the index would know how this company would be treated.

A third reason for using an index committee over a fully rules-based approach is to ensure diversification of the index portfolio or a "fit" of index members with the index's objective. Rules-based, capitalisation-weighted indices are often criticised for showing a bias towards booming and highly valued sectors, such as technology in the late 1990s or financials in the period before the ongoing crisis. On the other hand, these indices merely mirror the industrial and market developments in the respective markets at any given time and do—as they are by default supposed to—measure those markets accurately. A committee may intervene to maintain a broader sector mix, but in doing so would again take an active decision to modify the risk profile of the underlying market.

OFF THE BEATEN PATH: RULES-BASED CONCEPTS IN ESG

The case for the comprehensive construction of fully rules-based index concepts is easily made in markets with broad information availability and clear and broadly accepted measurement criteria such as market capitalisation, free float or liquidity. To illustrate how such rules might be applied in parts of the market where such criteria are less clearly defined, we will look at the area of sustainable investments in the second part of this article.

There are no commonly agreed definitions of what makes a company's activities "sustainable". Many investors in this area focus primarily on environmental topics, while others include the areas of social responsibility as well as governance (together ESG) in their considerations. Many ESG investors follow an index-based approach, despite a distinct lack of transparency when it comes to the underlying data and methodologies. This has been achieved with the help of specialised research providers, using proprietary rating methods. An index provider would typically join forces with the research firm, using the latter's rating methods for the selection of index components. Investors are then confronted with the fact that many of these ratings methodologies are proprietary and non-transparent. Ratings methods may also be inconsistent from one firm to another. Many of the traditional advantages of an index-based approach, such as full clarity over selection methodologies, have therefore not been available to investors.

In 2011 STOXX introduced a rules-based approach to selecting components for an ESG index. The model focuses on 128 so-called key performance indicators (KPIs) based upon an open standard developed by the society of financial analysts in Germany (DVFA). The model assigns a sector specific weight to each KPI, allowing the construction of a uniform score across all rated companies. Data for the KPIs is supplied by a research firm, Sustainalytics.

The rules-based approach, while addressing the transparency and consistency issues, is not without its challenges. Due to the breadth of the topics included in the environmental, social and governance fields, the weight of selection criterion is typically low, often not exceeding 10%. This approach works well as long as a positive screening approach is feasible.

 

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