Amid the turmoil caused by the European Securities and Markets Association (ESMA) report last July on ETFs, one paragraph in particular has caused alarm in the index fund industry. Its impact extends beyond the report’s original remit of ETFs and could transform the custom indices that underpin the €75bn alternative UCITS industry.
Most index fund providers correctly suspected that the long-awaited report would push for increased index transparency. But buried in the 58-page document came a potential bombshell that few had been expecting.
Towards the end of the report, in the section on financial indices, the Paris-based regulator appears to call into question the validity of the hundreds of so-called custom or strategy benchmarks that have sprung up over the last decade. ESMA states: “An index should not be considered as being an adequate benchmark of a market if it has been created and calculated on the request of one, or a very limited number of, market participants and according to the specifications of those market participants.”
The index fund industry, already dismayed by earlier guidance designed to limit the complexity of indices, was taken aback. “Right from the start, when ESMA first issued its guidelines in July, this paragraph raised questions,” said Antoine Moreau, deputy chief executive officer at Ossiam, the exchange traded fund and smart beta subsidiary of Natixis Global Asset Management.
Some of the debate around this section has come down to the definition of “market participants”. Nobody is entirely sure what ESMA means by this phrase. Some people argue that the regulator means index providers, in which case, with just one market participant behind an index, the resulting benchmark might no longer be acceptable. Others disagree, saying that “participants” mean end-investors, of whom there are usually plenty, so allowing the index to meet ESMA criteria.
“The way that ESMA defines custom indices as being created on the request of one investor or a limited number of investors does not necessarily signal an opposition to innovation or strategy indices,” said Frédéric Ducoulombier, director at EDHEC Risk Institute–Asia. “ESMA may be concerned by the possibility of conflicts of interest and abuse, whereby an index would be designed under the influence of an investor or group of investors with a view to then offering it to the detriment of third parties.”
“This reminds me of scandals in the collateralised debt obligation (CDO) space in the US, where some CDO structures were put together at the instigation of certain hedge funds, with the idea of subsequently betting against the vehicles without the knowledge of the long investors,” added Ducoulombier. “Esma may be trying to protect investors against this type of scenario.”
Potential conflicts of interest within firms creating both indices and funds may have pushed ESMA into drafting this contentious paragraph, others agree. “We believe that the impetus for this guideline may be to prevent an ETF provider from being both the publisher of an index and simultaneously managing a product based on that index,” said Dave Guarino, a spokesperson for S&P Dow Jones Indices.
“As an independent index provider, S&P Dow Jones Indices does not manage products based on its indices or those it calculates for its custom index clients, and therefore is not readily prone to such conflicts of interest, “ added Guarino.
The guidance has caused turmoil due to uncertainty over its exact meaning. “We have been very concerned with what this means and which indices are affected,” said Jarkko Syyrila, deputy director general of the Brussels-based European Fund and Asset Management Association (EFAMA), a Europe-wide lobby group representing asset managers with €14 trillion in assets under management. “It is really vague. There is no clarity on what they want to prohibit.”
EFAMA has written to the regulator, asking for clarification of what ESMA meant when it wrote about indices created and calculated for a limited number of market participants. The fund association hoped ESMA might respond in the clarification released on March 15, when the regulator responded to industry queries. “We wrote to them asking for clarification on this and other issues. They came back with a Q&A, but unfortunately didn’t add any clarity on this issue,” said EFAMA’s Syyrila.