Investors Pay For Index Changes

[This article was first published in Dutch magazine FondsNieuws in October 2015. The interview was carried out by editor Harm Luttikhedde, and the article has been translated and republished here with permission]

The end client is the one who pays for index changes, and there are often more changes than we know about.

Mark Adema is a leading Amsterdam-based expert on investable indexes, their transparency and costs, and argues that index providers have more work to do in order to prioritise the needs of the end client.

For years, Adema headed up the index department of Euronext. Since 2009 he’s been working as an independent index business consultant. And in 2014, derivatives exchange The Order Machine launched Adema’s design for the NL20 Index, a cost-efficient alternative to the mainstream Dutch index of his former employer, the AEX.

Why is it important to concentrate on your underlying index?

Adema: The advance of index investing is unstoppable. In the U.S., most of the flows into funds is of a passive nature. Europe – as always – will follow. The prime trend therefore is from stock picking to index picking.

To appeal to investors, each such index needs a clear and well-defined investment proposition. Yet all kinds of index rules tend to make index products unnecessarily expensive. Full transparency on such costs is paramount for index providers to give added value to the passive world.

How is the market of investable index providers currently structured?

Adema: There are two main groups. One group consists of exchange-owned indexes, such as the AEX and CAC40 of Euronext. A second group is made up by indexes of the “big four”: MSCI, S&P Dow Jones, Russell and FTSE – though the latter is now completely owned by the London Stock Exchange.

So what’s your issue with the current structure?

Adema: Take MSCI and Euronext for example, an example of an index from each of the two groups. MSCI’s business model is primarily based on benchmarking: market professionals will use the index to measure their own performance. Such benchmarking indexes tend to have many constituents.The MSCI World for instance – launched in 1969 – contains over 1600 stocks and was not designed to be efficiently tracked by vehicles such as ETFs. Nevertheless, such broad, well-known benchmarks are marketed amongst issuers of such index products.

Something similar applies to Euronext. They use their indexes for other purposes then investments as well, in particular to attract new listings. That [listing activity] has its consequences.

Dutch bank ABN Amro hopes for a speedy inclusion into the AEX index as well, in November or December. Does that have an impact on the investor?

Adema: For an index investor, does it make sense to immediately buy each new stock that is listed? No. One considers it for a while before deciding if the stock properly fits in a long-term investment. And ultimately, it’s the investor who has to pay up for all such changes in the index basket.

Which kinds of costs are you referring to?

Adema: So-called “fast entries” of stocks into indexes reduce index predictability, which broadens the spread of index futures. On top of that, it raises implicit and explicit transaction costs for ETF investors, for instance. And such costs add up substantially and incrementally, especially in the longer run.

So, especially with popular fads such as factor investing, it is imperative to consider the cost factor. The turnover within the index basket is about four times as large as within a market cap weighted index. I’m all for innovation but I believe indexers must be candid about all the cost that turnover may upturn. Never forget that, in the end, costs are the best indicators of performance.

During your years at Euronext, weren’t you also responsible yourself for commercialising indices?

Adema: Yes, and in doing so the index business was treated as a separate profit centre – clearly separated from the Euronext listing business and trading business.

In recent years Euronext transaction incomes have been under pressure due to increased competition. Listing fees have therefore grown in importance for the organisation as a whole. Issuer-friendly index rule changes were made at the expense of AEX investors. No less then nine such rule changes were made since 2006, like higher review frequencies and fast listing entries.

Is full [index and cost] transparency possible?

Adema: Things are surely heading that way. Especially in the UK and the Netherlands, regulators have taken important steps in that direction. Various sources of costs, now only implied in the tracking difference [performance gap between an index and a vehicle tracking that index], can well be assessed to calculate a total cost of ownership of an investment.

Will the NL20 index eventually dethrone the AEX Index?

Adema: That’s an issue which has various influencing factors. Things won’t change if cost transparency is not challenged or as long as regulators tolerate that lack of transparency. In any case, if the AEX had been compiled by an independent party, all these recent rule changes would not have been implemented.

Copyright Fondsnieuws (part of Investment Publishing International, a subsidiary of FD Mediagroep). This article is subject to the copyright statement of the IPI/FD Media Group.