One of the key arguments for investing in indices is often cited as transparency of the index rules. But how transparent are these rules in practice and how reliable is their application? In this article, we will examine the management practices for two groups of indices: a group of the widely used blue-chip indices and the newer area of sustainability (or ESG) indices.
While indices depend upon a number of rules to function, all of which are generally associated with the promotion of transparency, this article will focus only on those rules which determine the composition of the respective indices, as well as those handling the treatment of major corporate actions affecting the index composition. Similar arguments can, however, be made for all other aspects of the index calculation as well, even though the effects may be less visible to the general investor.
A LOOK AT MAJOR BLUE-CHIP INDICES
First, we will look at the major blue-chip indices. All of these indices share the attribute that they claim to represent the largest or most important stocks in a specific country or market. It is hence often the common perception that these indices automatically contain the largest companies by market capitalisation. In practice, however, these rules are often more complicated and actually significantly less rules-based than the initial perception suggests.
It is common practice for indices to be governed or advised by an index committee, made up of indexing and market experts. However, the role of these committees in determining the index composition varies extensively from one index firm to another. Broadly speaking, index committees' influence on blue-chip indices can be divided into two categories.
First, rules-based indices use a set of quantitative algorithms to determine the index composition at pre-defined intervals, or in response to corporate actions. In this case, index committees take a secondary role, with any changes to index rules taking effect at future points in time. The committee does not decide per se on the actual composition of the index, focusing merely on future rule changes. The committee may, however, also intervene in a short-term manner in cases where the potential harm to index investors from a strict application of index rules might outweigh the benefits of predictability. One example would be the exceptional spike in the stock price of Volkswagen AG, a member of the DAX index, in 2008.
Volkswagen shares briefly hit prices of over €1,000 per share—making the German car manufacturer the largest publicly traded company in the world. The resulting increase in the weight of the shares in the DAX index to over 25% vastly exceeded European regulatory mutual fund diversification requirements, as set out in the UCITS directive, and the DAX index committee advised to take immediate measures to cap the weighting of the component to a compliant level. The index provider also acknowledged that an update of the index rules was required and this was duly executed shortly afterwards by introducing a set of rules to create a transparent basis for dealing with similar cases in the future. It is this continuous improvement of index rules that ensures an overall minimal level of interference in rules-based indices.
This type of committee will be referred to as "rule-setting committee" going forward. Well known examples for fully rules-based indices are Germany's DAX, the leading European equity benchmark, the EURO STOXX 50, or the UK's FTSE 100.
By contrast, in committee-driven indices the committee takes a significantly more active role. The index rulebook usually defines a framework or principles for decision-making. The rulebook does not, however, prescribe index changes based on quantitative measures. Instead, changes are determined by the decision of the committee, according to the defined guiding principles. The committee—which we will refer to as the "committee" or "index committee" going forward in this article—may also review the principles during their meetings. Among major indices in this group are the US equity benchmarks S&P 500 and the Dow Jones Industrial Average.
It's clear that indices from both categories have enjoyed considerable success, and good arguments can be made for either method. Below, we contrast the two methods and outline the advantages and disadvantages of each.
For their primary use as the basis for passive investment strategies and investment products such as futures and options, ETFs or certificates, one of the key aspects that investors look for in indices is exactly this passive nature. A passive, index-tracking approach has been shown to provide superior returns over the average returns of actively managed strategies, according to multiple academic studies of mutual fund returns. Fully rules-based indices comply with this value proposition as they will always duly execute the published and transparent index rules, and are hence by definition fully passive.
By contrast, a committee with direct influence on the composition of the index brings a judgemental or active component to the way the portfolio is constructed. In order to understand this, it is worth examining the types of decisions that an index committee usually faces. As stated above, in most cases the objective of the index is pretty clear (for example, to capture the largest or most influential companies in a given market). A committee might therefore need to override this implicit algorithmic choice of companies.
So Why Would This Be Necessary?
The first argument for this is index continuity, or the aim to make as little change to the index portfolio as possible: in other words, to avoid "unnecessary" turnover. This might entail a company being allowed an extended stay in the index in the event it breaches the relevant thresholds, under the assumption that the company may bounce back by the next index review. Rules-based indices do and need to allow for extra continuity by introducing special buffer rules—which define how much "goodwill" should be assigned to any company on the threshold of index exclusion or inclusion. The judicious setting of these rules, in order to ensure index continuity, is one of the key functions of the rule-setting committee.
In committee-driven indices the decision on index inclusion or exclusion remains with the committee, which effectively takes an active decision on how long to stick with a specific company that has dropped out of the original scope of the index. This leaves significant elements of uncertainty over the future index composition. In turn, the index composition plays a major role in determining the pricing and risks of long-term derivatives contracts, for example, dividend points swaps and futures.
Not only do market participants looking to evaluate the long-term characteristics of indices need to forecast the stock price performance or changes to the corporate and shareholder structures of companies at or near the index threshold, they also need to evaluate the committees' likely decision and timing. One example for this is the case of General Motors: the company's large stock price decline in 2008 and 2009 saw the share drop out of the group of the largest US-listed companies. While Standard & Poor's adjusted the S&P 100 Index as early as July 2008, it took until June 2009 until the share was finally dropped from the Dow Jones Industrial Average, which comprises only 30 stocks. It was around the same time that Standard & Poor's dropped the firm from the S&P 500 Index, indicating that GM was at the time in fact no longer reasonably within the largest 500 stocks in the US, let alone the largest 30. In rules-based indices, similar declines in market value would lead to a much quicker exclusion from the index. The STOXX Europe 50 Index applied its fast exit rule in December 2011 to replace French insurer Axa, which had fallen below the threshold for inclusion. In Germany the share of Infineon was dropped from the DAX index in March 2009 following a sharp decline in its market value, triggering a fast exit. Incidentally, the company returned to the index six months later after a sharp recovery in its share price.
It is exactly this rapid exclusion and re-inclusion of index stocks that committee decisions attempt to remedy—by taking an active view on the future performance of certain components. Unfortunately the case of Infineon remains a rare example—most companies leave an index for good and the added value of delaying the exclusion for the sake of continuity seems questionable. In Figure 3, we give the statistics for companies that have re-entered a blue-chip index from which they were previously excluded. The statistics show that such occurrences have been very rare in the past ten years and that on average such companies have taken almost two full years to return to the index, justifying the exclusion in the first place.
The obvious exception in this table is the FTSE 100 index, which shows a high number of returning companies. During the period, companies such as Whitbread, Tate & Lyle and Kelda Group returned to the index twice or more. In this case, the buffer of 10% chosen to prevent frequent changes to the index composition seems to be too small to achieve its objective, especially given the relatively small and hence quite volatile market capitalisations at the lower end of the FTSE 100.
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.
However, sustainable investing is often dominated by a focus on negative publicity such as that resulting from major disasters like the Deepwater Horizon oil spill and the Fukushima nuclear accident, which affected companies like BP, Transocean and Tepco. While in such incidents companies found liable would certainly score 0% on a pollution criterion, an ESG model could still return high overall scores under a strict rules-based application, since the model does not account for the level of severity of a potential breach.
Here, an individual research analyst might employ common sense to adjust models for individual stocks, based on investor perception. But as in the previous discussion of index committees, this would represent a significant active intervention into a passive investment approach. By making such a judgement, the analyst and the index concept based on it would assume that all investors share the opinion that the specific criterion is to be overweighted given the circumstances.
The rules-based concept makes amends for this issue by introducing fast-exit criterion, leading to exclusion of companies that show significant breaches of the UN Global Compact criteria, as set forth by the United Nations. This is a good example of how the governing rules for such rules-based indices can be adjusted to deal with potential issues in the index construction methodology. However, at the first occurrence of unexpected news, a committee- or research-driven approach has the advantage of increased flexibility.
Another core argument for the traditional approach is that the research provider with analytical capacity is simply in a better position than an individual investor to evaluate the sustainability of a company. The investor is thus able to "outsource" the definition of sustainability to a reputable third party and go along with that party's values and definitions. An added benefit of this is that the asset manager can outsource stock selection to the independent research house.
However, today we notice an increasing demand from investors who are willing to take an active responsibility for the sustainability of their investments and want to combine this with their own core values. This can easily be observed by tracking the number of firms that have signed up for, as well as the assets managed in accordance with, the United Nations Principles of Responsible Investing (UNPRI). The growth has been exponential in recent years. It is this group of highly educated and sophisticated investors in sustainability, who have their own views and a clear understanding of the definition of a sustainable company, who can make the most use of a rules-based approach. Of course, many of those investors' opinions on the valuation and relative weightings of the individual KPIs will differ, just as individual definitions of sustainability differ. The advantage of a rules-based selection approach is that the rules can easily be customised and, in contrast to a proprietary research approach, any differences in valuation are clearly visible.
To sum up, we believe it is fair to say that while the value added by an index committee's selection of stocks or index components can be found in the areas of continuity and diversification, the committee approach does add a significant active component to the index. This contradicts the passive nature of the index and adds an element of unpredictability and, ultimately, risk to the indexing equation. Depending on the investor's expertise, this active intervention by the index committee or research provider may add more or less value.