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Index investing: Its continued rise and the market’s growing need for clarity

Beth Savino US ETF Leader and Index Transparency Solutions Leader, PwC US November 12, 2020

The shift from actively managed products to passive investing strategies via index-based funds is a trend that is often discussed. But what’s less talked about is how this change has affected financial market risk and investor confidence. In many ways, index-based funds are something of a black box. 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.

Of course, no one involved likes this lack of clarity, which is compounding with the growth in index-based investment strategies. And it’s why we’re now faced with a widening transparency gap. It creates greater risk, such as investors allocating capital to index funds they don’t fully understand and fund sponsors being liable for errors. What’s needed is a way to instill greater transparency in the financial index ecosystem. Here’s what’s at stake and what you should consider.

Understanding the challenge

With index-based funds, investors can buy into a single fund that replicates the performance of an index composed of many securities and designed to meet stated objectives. Index-based funds are offered through a variety of financial products, including mutual funds and exchange-traded funds. As the use of index-based funds has grown, so too have market incidents attributable to index errors.

In 2020, for example, a large investment management company agreed to pay investors millions of dollars after failing to rebalance one of its mutual fund offerings, causing a deviation from its benchmark. The prior year, company stocks in non-ESG-friendly sectors, such as weapons and gambling, were erroneously included in an index tracked by ESG funds. This error meant that socially responsible investors were exposed to investments that weren’t aligned to their objectives or the representations of the fund.

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. Though index providers develop proprietary methodologies, they have to rely on data collected from company disclosures or other sources to construct the index. 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. Moreover, issues like these are in turn exposed to the investor community through investment products that are referenced by or linked to the index.

Regulators are taking notice

While more needs to be done to increase transparency related to how indexes are constructed and used, there is ample evidence that regulators are aware of this issue. Some regulators have even taken concrete steps to address these issues.

For example, the EU Benchmark Regulation (BMR) was introduced amid concerns about the accuracy and integrity of indexes used as benchmarks in EU markets following the LIBOR scandal. BMR imposes requirements for organizations that provide, contribute data to and reference financial benchmarks.

While BMR represents the first move by a foreign regulator to impose requirements on index providers, 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.

What should index administrators and fund sponsors do?

While regulators study these issues, you should be exploring measures that can mitigate the risk of financial and reputational loss stemming from the transparency gap.

Here are some relevant questions to consider:

Index administrator

  • Are my index methodologies applied consistently and accurately?
  • Do I assign ESG factors and/or optimize my indexes in a reasonable and consistent way?
  • Is the risk of fraud and error sufficiently mitigated through controls?
  • What is the reputational risk and potential economic impact associated with errors?

Fund sponsor

  • Is my portfolio true to the objectives of the fund?
  • Do my index providers have controls designed to ensure the accuracy of data provided?
  • How do I know whether the controls and operational processes at my index providers are operating as intended?
  • Does my due diligence process over my index providers need to be recalibrated in light of the current environment?
  • Do I have sufficient oversight controls in place to mitigate issues attributable to index errors in times of market volatility?
  • As a fund manager, am I maximizing my licensing spend to replicate the index, while assessing my cost?
  • What is my exposure attributable to reputational loss as a result of an index error?
  • Are there processes and controls surrounding rebalancing functions?

What’s next?

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. 

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