Changing The Index Rules

May 14, 2012

Index Disclosure

ESMA’s proposals on index disclosure drew strong support from Morningstar.

“We would emphasise the need for greater transparency around the methodologies, constituents, and embedded costs of strategy indices,” said the firm. “As it pertains to these considerations, the proposed guidelines are spot on.”

Amundi echoed this but introduced a note of caution in its submission to ESMA: “Greater transparency in index-tracking funds is very welcome, especially regarding indices’ methodology and composition; nevertheless the degree of transparency relies on the ability and willingness of index providers to disclose such information.”

Responses from index providers have unsurprisingly concentrated on ESMA’s demands for better disclosure. The provision of indices has become a big business and index providers are strongly motivated to defend their business models. At the same time, respondents from all sides of the industry have pointed out the intellectual property and competition issues that are raised by the proposals. Under ESMA’s draft guidelines, index providers will need to publish the full details of an index’s composition, a level of information that is often currently available only to the holders of index licences, purchased from providers.

In a joint submission, MSCI, S&P and FTSE, who recently combined to form an index industry trade body, argue that ETFs themselves provide sufficient disclosure of index composition in their daily portfolio composition files (or PCFs). While this initially seems like a reasonable observation, ETF managers often use sampling techniques to determine their fund holdings so a fund’s composition can be quite different to that of the index being tracked.

Many respondents to ESMA’s consultation paper question the need to change the current arrangements. For example, Ossiam argues that: “Currently, some index providers agree to give the composition of an index, but with a lag, in order to prevent front-running by arbitrageurs and to protect the intellectual property linked to the index. We think this is the appropriate setup and that we should not impose a real-time availability of the index components.” This view was supported by EFAMA and IMA (the UK asset management trade body).

The consultation paper also proposes mandatory disclosure of the index calculation methodology. This is the norm for benchmark indices—although, as Amundi points out, some benchmark providers, MSCI for example, withhold these even for "vanilla" indices. Many strategy indices involve proprietary investment rules that index providers have historically been unwilling to disclose.

But not everyone agrees that the full disclosure of index methodologies is necessary; Deutsche Bank argues that “proprietary methodologies are the basis on which investment managers compete and are therefore commercially sensitive. Therefore, they should not be required to be fully disclosed. As long as an investor understands how the index operates and in which assets it invests—via appropriate disclosures—the interests of the investor are sufficiently protected.”

RBS also points out that “several regulators accept the disclosure of a redacted version of the methodology or full publication via a secured website only accessible by existing investors. These indices may nonetheless comply with UCITS index regulations and be fully rules-based as required. We believe that a redacted version of the methodology is sufficient, provided that it provides the necessary information to fully understand the mechanisms, techniques, composition and rules of the index.”

The disclosure debate shows how commercially sensitive ESMA’s draft index guidelines are. Supporters of strategy indices point out that they fulfill an important role in allowing investors access to markets and systematic strategies that would otherwise be unavailable. Yet, say many industry firms, the desired disclosure levels threaten existing business models, as well as possibly also leading to the front-running of index changes, something that could damage investors.

Whatever ESMA decides when it issues its final guidelines later this year, it’s clear that not everyone is going to be happy with the outcome. If mandated, increased levels of disclosure of intellectual property represent a big challenge to the index industry. ESMA’s proposals also have the potential to inflict profound changes on the management of active, as well as passive funds.



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