What’s Inside Your Index?

February 27, 2012

While most benchmark indices have simple structures, strategy indices often come with embedded complexity and extra costs.

 

[This article originally appeared on our sister site, IndexUniverse.eu.]

 

By contrast with benchmark indices, which usually select constituents by a simple measure like market capitalisation, strategy indices encapsulate a systematic investment process or algorithm within the selection and calculation methodology. Investment products (funds or notes) tracking such indices will usually gain economic exposure to the index via a swap (or option) obtained from an investment bank. Just as the calculation of a fund’s net asset value (NAV) per share will take into account purchases and sales of investments, as well as investment income, gains, losses and operating expenses, the calculation of a tradeable index will also include some measure of each of these components. The objective is that, as far as possible, what you see in the index is what you receive in the end-product.

It pays to look hard at possible layers of costs inside the underlying index before you select an index fund, ETF or structured product. Below we examine industry practice in managing strategy indices and point out what to look for and where to find information on costs.

Costs And Fees

Trading costs are an inescapable part of investing and indices designed to be tradeable usually make some adjustment for these costs. Typically an investor will not be able to match precisely the prices used in an index’s calculation. This, in turn, will result in some day-to-day tracking differences between the investor’s portfolio and the index. Over short time periods such effects are often small, but when the index is rebalanced this price difference is “locked in”, resulting in a permanent shortfall in the replicating portfolio when compared with its underlying index.

Tradeable indices attempt to minimise this shortfall by making a so-called “rebalancing adjustment”. Such adjustments can be as simple as taking into account the market bid/offer spread when buying or selling assets during the index rebalancing. In this way, the index is mirroring the costs that would be incurred by a fund undertaking the same operations. Where the bid/offer spread is not available or is unreliable, a common alternative is for the index to apply a fixed rebalancing cost, which captures transaction costs but also includes a margin to allow for expected price slippage (where the investor cannot trade at or close to the prices used in the index calculation).

In less liquid markets (for example, emerging market equities and bonds and, especially, in options markets) both slippage and bid/ask spreads can vary widely, particularly during periods of market stress. To accommodate this, some indices resort to relatively complex rules to calculate rebalancing costs. For example, the JP Morgan Macro Hedge strategy index tracked by an ETF the investment bank has recently launched in partnership with Source has a rebalancing charge of between 0.2 percent and 0.5 percent on each monthly futures “roll”. The level of this charge is set by the underlying VIX index, with 0.2 percent applying when the VIX is below 35, 0.5 percent when the VIX exceeds 70, and a sliding scale in between. The roll cost applies to both long and short positions in the index, implying that total roll-related expenses could approach or exceed 10 percent a year.

A high proportion of strategy or hedge fund indices used in listed investment products also take out a fixed fee from the investment return. This fee is used to pay for the management of the index hedge portfolio and may also include an index management fee. These fees are usually taken from the daily asset returns. For example, the JP Morgan Macro Hedge US TR Source ETF levies a flat index fee of 0.75 percent a year.

Where To Look For Index Fees

Index providers often have several different versions of an index. So, before anything else, note the exact index name and don’t assume that all indices in a family operate in the same way. For example, the iShares iBoxx Euro Corporate Bond fund (LSE: IBCX) tracks the iBoxx Euro Liquid Corporate Bond index from Markit. db X-trackers’ Euro Liquid Corporate 100 ETF (Deutsche Boerse: XBLC) tracks a similar index from the same provider. But while the iShares fund uses bid and offer prices on the underlying bonds to rebalance, the db X-trackers fund charges an “index replication cost” of 0.4 percent a year. These two cases illustrate the different approaches to rebalancing adjustments that we outlined earlier.

 

 

When it comes to disclosure, the websites of strategy index providers vary widely and many currently provide little or no in-depth information to the public. Registered users (usually, banks’ direct clients) typically get access to more information. However, as we discussed in a recent article on IndexUniverse.eu (Shifting Gears On Strategy Indices) industry practice is set to change. The European Securities and Markets Authority’s ETF consultation paper, released in January, makes much of the need for additional transparency in strategy indices. Under the draft guidelines the index provider will need to disclose the full calculation methodology, allowing investors to replicate the index. This means that index costs, fees and payout structures will in future be fully disclosed for indices used in UCITS funds.

A more fruitful source of information on index fees and costs is the investment product providers’ websites, where you can find both fund and index-related expenses in factsheets or the fund prospectus. Even here we find that more complex structures, like the JP Morgan/Source ETF mentioned above, don’t reveal all the index costs in detail. In this case a potential investor would need to go to the JP Morgan indices website to find the full information.

In the US market it’s somewhat easier to find the relevant information. If the underlying index is to be used for a US-listed investment product, it should be possible to read the so-called “free writing prospectus” (FWP) on the SEC’s “Electronic Data Gathering, Analysis, and Retrieval” system (EDGAR).

Unfortunately, there is currently no easy way of comparing index expenses between products on a like-for-like basis. It would be a positive step for the industry to provide a standardised measure of index expenses (such as an index ”total expense ratio”), as well an all-in product level figure (or range), which would include both fund and index expenses.

Leveraged And Complex Payout Structures

As mentioned above, the daily index calculation is intended to mirror a fund’s NAV calculation in its treatment of expenses. That is not the end of the story, however. The index may also be structured to include fixed or active leverage or even more complex payout structures.

Leveraged ETFs, for example, may apply leverage at the fund level to an unleveraged underlying index, or track an index that includes a leverage factor in its calculation. In the latter case leverage is an intrinsic part of the investment strategy being pursued and is applied as a fixed multiple of the underlying index’s returns. However, leverage may also be used dynamically in so-called “risk control” indices (here, for example, an index’s exposure to its constituent assets may vary according to the volatility of those assets).

Risk control indices may follow a relatively simple, systematic asset allocation scheme (equal-risk-weighted indices are an example) or may target a set level of index volatility through a process of dynamic leveraging and deleveraging. In its ETF consultation paper ESMA recognises the use of leverage in strategy indices and proposes guidelines to ensure that the mechanisms employed in the index respect the UCITS diversification rules.

It is possible also to “index” a complex payout structure, such as one embedding financial options. Many so-called structured UCITS funds, whether index trackers or not, contain options, and such funds are likely to be classified as “complex” in the ongoing review of the Markets in Financial Instruments Directive (MiFID). At present UCITS are automatically considered as simple products and it looks likely that ETFs will continue to be treated this way.

However, as we’ve shown, complexity and costs can occur both in funds and in the indices underlying them. Hopefully, regulators will consider both fund and index structures when assessing financial products.

 

 

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