Welcome to the next era of transparency
The financial index ecosystem has become modern. Passive investment strategies have grown. Success depends on earning and keeping trust that the system works — all the time — without broken links in the chain. Investors demand it, competitors develop it, and regulators expect it. The complexity comes in bringing it all together with reasonable assurance that your objectives and the objectives of internal and external stakeholders are met.
So the burden is placed on the asset management community to adapt. And quickly.
With the pace of disruption and volatility, it can be challenging to see all of the moving pieces that shaped the challenge facing asset managers.
The rapid growth and customization of index-driven strategies has led to increased risk and scrutiny. In the U.S. Mutual Fund and ETF industry, passive investment strategies, including index-based investing, have outpaced active investment strategies in recent years. As part of this growth, the demand for greater customization in index-based investment strategies by investors has also brought with it a widening transparency gap.
Recent market volatility, including knock-on impacts of the COVID-19 pandemic on a global scale, has led to further scrutiny of the integrity of index data. The investing public expects that the composition of an index-based fund is aligned with its stated objectives; however, there are underlying dependencies on the integrity of data used that may not be as transparent, and this has become increasingly apparent during times of market volatility.
Responsible investing raises new questions and sheds new light on the integrity of ESG scores used in financial indexes. Because public companies are not required to disclose certain non-financial information, such as immaterial environmental or social information, the data set that index providers are relying on can be incomplete and lack consistency. Issues like these are in turn exposed to the investor community through investment products that are referenced by or linked to the index.
Market incidents attributable to index errors have led to greater concerns over financial exposures. Such errors can cause financial and reputational harm throughout the index supply chain. How do errors like this happen? It often goes back to the sufficiency and effectiveness of the underlying operational processes and controls relied upon throughout the index supply chain.
Increased regulatory scrutiny has placed additional pressures on index administrators. The EU Benchmark Regulation (BMR), which was introduced amid concerns about the integrity of benchmarks following the LIBOR scandal, represents the first move by a foreign regulator to impose requirements on index providers. In the US, recent speeches by commissioners of the US Securities and Exchange Commission indicate increased regulatory attention. This scrutiny could potentially lead to new regulation in the absence of a market response.
Operational issues and transparency concerns associated with the process by which indexes are constructed and used have been brewing for years. But it’s time to start thinking about how to mitigate the risks and close the transparency gap investors face in this popular corner of investing. Providing more clarity on indexes is not just a competitive advantage, it’s what the market needs. Our new index transparency solutions are designed to help you close this gap.
