One regulator has taken a step this year towards insisting on greater index transparency.
ESMA, Europe’s securities market regulator, has recently required from the managers of the region’s UCITS funds that they provide free and easy access to the full calculation methodology, constituents and weights of each index in which a UCITS is invested, as well as free access to performance information.
However, says EDHEC-Risk, on the basis of a study of 50 equity indices, measured against 76 transparency criteria, most index providers currently fail to provide information beyond a list of current constituents, and, in a significant minority of cases, index providers did not reveal any information on historical index constituents and their weightings.
Amenc and Ducoulombier say they will publish their research into index transparency early in 2013.
In its submission to the European Commission, EDHEC-Risk calls for the principles of index transparency set out by ESMA for UCITS funds to be extended to funds regulated under Europe’s Alternative Investment Fund Managers Directive (AIFMD), as well as to non‐fund Packaged Retail Investment Products (PRIPS).
But EDHEC-Risk is also calling for regulators to enforce much more fundamental changes in the structure of the financial index business.
“Whatever the stated corporate governance principles and the rules for the prevention of conflicts of interests, the existence and nature of a link between an index provider and an entity that will directly or indirectly benefit from the index provider’s decisions are a cause for concern,” say Amenc and Ducoulombier.
Amenc and Ducoulombier say that rulemakers should impose a strict separation between index provision and other financial activities. Index providers should not be allowed to trade for their own account and should not offer other financial services, they argue, nor should they be part of or affiliated with groups offering other financial services.
“It would be hard to fathom the judiciousness of allowing an issuer or an investment bank to own a rating agency; likewise, we are convinced that restrictions on the shareholding of index providers can be a fundamental and powerful tool to prevent conflicts of interests,” the EDHEC authors say.
The enforcement of a structural separation between benchmark providers and other financial institutions would represent a major upheaval for the index business, which has boomed during the last decade. Currently, many of the world’s major financial index providers are owned by banks, consortia of banks or exchange groups.
And the current practice of charging index licensing fees according to the size of assets under management in related financial products, the most common way of charging for an index in the passive funds market, should be ended, argue the EDHEC-Risk spokesmen.
“The regulator must look at the very structure of the business and revenue generation model of the index provision industry and question the performance‐based compensation arrangements imposed by index providers,” say Amenc and Ducoulombier.
“Index providers should no longer be allowed to receive compensation that is directly or indirectly related to the performance of their indices. The practice of charging fees in relation to assets under management should be discontinued,” say the EDHEC directors.
“To draw another parallel, it would be hard to fathom the wisdom of compensating auditing companies [by] reference to the performance of the companies they audit,” they argue.
