Indices play a crucial role in investment management, from strategic asset allocation to risk analysis and performance measurement. They serve as references for passive and active investment products and mandates, whereby an asset manager attempts to replicate index performance or deliver performance that is superior to that of the index.
While index provision is generally not a regulated activity, regulators have for long imposed qualitative restrictions on indices that could be used by retail funds. However, these requirements were relatively high-level. It is only recently, against the backdrop of the rapid growth and diversification of indexing products, and in the shadow cast by integrity issues with the oil price and interbank rate benchmarks, that indices have received closer scrutiny and the question of imposing higher standards of methodological quality, governance and transparency upon indices has been discussed.
In this article, we review recent regulatory developments and ongoing discussions related to indexing with particular emphasis on transparency, which has taken on critical importance with the emergence of new forms of indices.
UCITS Requirements As The Beacon Of Transparency
The “Product Directive” (2001/108/EC), which increased the investment freedoms of European retail funds (known as Undertakings for Collective Investment in Transferable Securities, hereafter UCITS), introduced the first reference to financial indices in UCITS regulation. The directive relaxed risk-spreading rules to allow for the replication of (apparently poorly diversified) “well-known and recognised” indices. It also permitted outright investment in financial derivatives and, recognising financial indices as an acceptable underlying for these derivatives, it created the possibility of synthetic replication. The directive authorised the replication of indices recognised by the competent authorities as being sufficiently diversified, representing adequate benchmarks for the market to which they refer and being published in an appropriate manner.
These requirements were first clarified by the “Eligible Assets Directive” (2007/16/EC). To be considered an adequate benchmark, an index must measure the performance of a representative group of underlyings in a relevant and appropriate way and be revised or rebalanced periodically, according to publicly available criteria, to continue to reflect the markets to which it refers. Transparency requirements with respect to publication are described as the “wide and timely” provision of “material information” on matters such as index calculation, rebalancing methodologies or index changes.
In July 2012, after one year of work and consultations that had initially focused on the exchange-traded fund (ETF) market, the European Securities and Markets Authority (ESMA) established new transparency requirements for index-tracking UCITS and updated the eligibility criteria of financial indices. These rules (ESMA/2012/832EN) are applicable to newly created funds since 17 February 2013—other UCITS have one year to comply. With respect to transparency, ESMA clarified that each index should have a clear, single objective and that the universe of the index’s components and the basis on which components are selected should be clear. ESMA went further and prohibited the use of indices that do not disclose their “full calculation methodology” or fail to publish “their constituents together with their respective weightings.” The regulator also required this information to be accessible easily and on a complimentary basis to investors and prospective investors. ESMA also prohibited investment in indices whose methodologies are not based on a set of pre-determined rules and objective criteria, or which permit the so-called “backfilling” of data.
One of the key objectives evident in ESMA’s new requirements is the regulator’s desire to restrict UCITS’ choice of indices to those that are built and managed in a systematic manner and for which index providers make available sufficient information to the public to allow for independent replication on a non-commercial basis, a precondition for informed investment decisions (ESMA underlines that detailed information on index constituents and on calculation and rebalancing methodologies must be available and that the parameters or elements needed for replication should not be omitted).