Exchange-Owned Indexes Cost More For Investors

Many leading national stock indexes are owned and controlled by the stock exchanges on which the companies in these indexes are listed. This ownership model applies to many of the main equity indexes in Europe – consider the UK FTSE 100, the French CAC 40, the Dutch AEX etc. This ownership model impacts how these indexes are managed, which in turn has an effect on the end cost for investors tracking these indexes. Ultimately this is because exchanges use their indexes to attract new company listings, creating more turnover within the index.

In the Netherlands, this situation has led to Euronext’s headline AEX index to be challenged by an independent alternative: the NL20 index. Will other countries witness similar alternative indexes soon?

Low Cost Indexes: A New European Trend?

Euronext is increasingly and inappropriately using its Dutch AEX index to attract new listings. This has led to more turnover in the index basket at the expense of index investors.

The AEX index was originally developed as an investable benchmark of Dutch blue chip companies, but now, the interest of listed companies is being put first. The NL20 index, developed by rival TOM MTF, is an independent and cost-efficient alternative.

More Turnover Means More Investors Expense

It is true that index reviews – where companies are reweighted and some are added to the index and some are dropped, depending on whether they fit the index criteria – lead to turnover and thus to cost. Between 2005 and 2014, the annual turnover at AEX reviews was thirty percent higher than for the NL20, which amounts to an extra €33,000 every year per million euro of index-linked investments. With an estimation of at least €34 billion of investments tracking the AEX, that amounts to over €1.1 billion needlessly turned over per year. The data is publicly available here.

There is no such thing as a standard model for indexes. Individual index providers make their own choices on things like how often they will review the index, the numbers of constituents, weighting methods and so on. However, indexes do have one thing in common: they offer investors the free lunch of diversification. This effect is achieved pretty quickly by about 20 constituent companies. Additional tweaking of index rules has little extra effect on diversification and index price performance, and is more expensive for index investors.

Companies’ Needs Prioritized Over Investors

Applicants for listing on Euronext Amsterdam rank inclusion in the AEX high on their check list – and they want it as fast as possible. That also applies to non-AEX companies that are already listed. They clamor for a successful entrance into this market, as through the various AEX-tracking products, index inclusion automatically leads to demand for their shares.

Euronext facilitates this desire generously. Listing income is given priority now that competition erodes transaction and clearing incomes. Since 2006, no less than nine such AEX rule changes were implemented: higher review frequencies, fast entries, qualification of exotic companies and abolishment of the index user council. These measures have affected the independence and cost-efficiency of the AEX, at the expense of investors.

Wider Spreads On AEX Derivatives

Efficient derivatives markets should provide investors competitive bid and offer prices – in other words, the prices to buy in or sell out. Because derivatives are forward contracts, the more predictable the underlying value, the tighter the spreads. The AEX rule changes have affected this predictability. Until 2008 there was a single annual review: now there may be four of them in the course of a year. The NL20 is considerably more predictable, with as a rule only one annual revision.

Fast entry rules were also introduced for the AEX, and constituent changes are announced just two weeks in advance – which compares to three months for the NL20.

The AEX rules on inclusion of non-Dutch stocks, implemented in 2007, imply cost. More constituent changes are likely as these companies might come to Amsterdam for fiscal or technical reasons and be listed for just a short period. On top of that, for various non-Dutch companies, a Financial Transaction Tax is considered. The NL20 index avoids such costs and does not admit non-Dutch companies.

Finally, Euronext charges issuers of AEX products license fees, and sells the necessary index data to professional users. Eventually, this cost is borne by investors, who thus unwittingly pay for attracting listings. The NL20 is independent, and gives first priority to investors’ interests.

In my view, indexes should be independent and transparent about costs – regulators increasingly stress this as well. My article raises questions over the nature and extent to the true cost of index investing.

Mark Adema is index consultant and involved in the development NL20. Until 2008 he was director of Euronext Indices BV.