In Part One of two-part series, The ETF BILD team sat down recently with Index Industry Association (IIA) CEO to discuss the evolving world of index regulation and its implications for the ETF industry.
Part I – Global Regulatory Landscape for Indexes
BILD: Rick, thanks for making time for us. These are interesting times to say the least. Looking through the lens of ETFs, we’re seeing and hearing about interesting developments in the US market, particularly as they relate to the potential regulation of indexes. The SEC is evaluating whether a benchmark change should be subject to a shareholder vote. Do you see that the US regulatory regimes are becoming more interested in the index area? How does the IIA think about these issues?
Rick Redding: First, thank you for having me. There’s a couple things to think about in regulation and what’s been happening across the globe over the past eight years or so. It is important to note that self-indexed price assessments like LIBOR are very different from independent index administrators that mitigates the conflicts of interest exhibited in the IBOR crises. Following the LIBOR crisis, IOSCO created Principles for Benchmarks to help establish principles to bring transparency, reduce conflicts of interest, and bring confidence back to the market.
Different countries have taken different approaches. Asia, Japan and Singapore began regulating their local IBORS after the scandal. The UK started regulating LIBOR and other indexes that they deemed to be critical to the UK economy including, a couple of foreign exchange rate benchmarks, some overnight interest rates, and selected commodities.
The EU has become the regulatory outlier. They proposed to regulate any index regardless of type. Though meant to be all-encompassing, the EU may have underestimated the sheer number and complexities of benchmarks across asset classes. IIA members alone administering about 3 million indexes.
By contrast, the US regulates markets very differently. If you think about how the Securities and Exchange Commission (SEC) and its securities laws are constructed and how the Commodity Exchange Act (CEA) was created, they tend to look at end-products and regulate them accordingly as these are what investors buy, sell, and trade.
Remembering back to the LIBOR crisis, it was in fact the CFTC that collected the fines in the early days of the scandal because there was not any direct regulation in the EU against the violative behavior, whereas the CFTC has jurisdiction to regulate all commodities and futures.
The US did not go down the path of the EU because the CFTC already demonstrated that they could regulate them through the CEA. If the SEC or any other regular regulatory agencies were to start regulating benchmarks, it would be very different from the historical pattern of focusing on products. Observers sometimes confuse the regulation of the index based product that people invest in with the underlying index that the product tracks; many market participants don’t realize that these are two different things. The underlying holdings of the fund portfolio may actually differ from the underlying index. A fund is subject to investing according to the prospectus and/or suitability requirements; an index does not make investments in securities, but is based on its methodology on index construction, administration, and maintenance..
BILD: So, continuing on that, what is the appropriate approach or framework for index regulation?
Rick Redding: In the US, when you regulate the product, you can effectively see through those products to regulate the different pieces. It is the investors’ experience with the investment products that regulatory authorities should care about.
They regulate the products by regulating the asset manager or issuer that is the product provider, who replicates the index by buying either the entire basket of securities or a sampling of the representative basket.
Twenty years ago, when most indexes were market capitalization-weighted indexes, some felt those indexes are more straightforward. But we’ve seen significant innovation in the industry since then. The industry offers different asset classes, weighting schemes, and rules-based indexes that more closely represent strategies, factors, and themes.
So today, in looking at self-indexed products the SEC is wondering: are there adequate firewalls in place so that any potential conflict of interest is mitigated? Are the boards of directors of the issuer of the product different from the index provider? Investors have benefited from having a third party effectively administering the index, with another set of eyes overlooking to make sure that the methodology and the rule book or handbook is being followed exactly as it should be.
BILD: What is the conversation among IIA members on U.S. index regulation?
Rick Redding: That is not as straightforward because in the US the regulation is, as you know, divided up between different regulators.
If the SEC regulates a mutual fund or an ETF in one way, and the CFTC regulates a futures contract a different way, and both products are based on the same underlying index, that could be very confusing to investors. There may be very good reasons for the multiple regulators so it’s hard to say what the optimal regulatory framework. Again, the fundamental issue is: isn’t the product what investors care about because how the product is managed impacts their return.
If you go back to the formation of the IIA, you can see the need for the IIA. IIA was actually started prior to all these crises, because some of the members recognized that they were only as good as the weakest firm in the industry. So, the first thing we did was create the IIA Best Practices that all our members need to adhere.
BILD: Right, and wasn’t the other goal of IIA was protection of IP?
Rick Redding: IP protection is a foundational element that all IIA members must adhere to because that is ultimately what the industry believes is most vital. In this day and age of technology and big data, you and I could create an index tomorrow. The issue is credibility, reliability, and objectivity.
It’s the reputation of the index provider and the intellectual property (IP) that matters, and that brings us to the issue of self-indexing. There are some asset managers out there that have created strategy-type indexes based on their proprietary algorithms and they are entitled to that IP. But it’s about their motivation: are they creating the index to protect their IP, or are they creating their own self-index products to save on fees, or both? We should focus on what is best for the investor and their protection.
The classic idea is to look at self-index IP as being owned by the asset manager; however there can subtleties in the process. Indices can still be administered by a third party, and that would give you that extra layer of protection from potential conflicts of interests. History has proven investors benefit when the conflicts are mitigated.
BILD: Do you think regulators are going to look at the issue of regulating the names of the product and the index, ensuring that they line up better with each other?
Rick Redding: The SEC is gathering input to determine if the names of funds could be misleading to investors. The investing market has certainly changed since they last looked at the issue, and if there were an easy answer, I think the industry would coalescence around a solution, but there are some difficult issues within this area.
For one, the growth in the number of ESG products is an important piece of it. How do you delineate between product names? Second, is there a way to delineate or find a more granular way to assess an appropriate name against the underlying constituents? Third, there are many more strategy and thematic funds; there are more derivatives in funds making some of the existing percentage of asset tests more difficult.
Thus far, they haven’t hinted they’re going to change anything, but they’ve noted that this is an increasingly complicated area for oversight. How does a better and more flexible method for new naming conventions actually help investors? Can the name of the fund convey enough information to really help investors? Ultimately it still relies on investors and their advisors doing their due diligence. Fortunately for index-based products, the responsible index providers publicly make the methodology of their underlying indexes available.
BILD: Any other regulatory issues to have on our radar?
Rick Redding: Absolutely. The third-country benchmark regulation in Europe continues to perplex firms located outside the EU. The asset management community with European clients has slowly begun to realize that as of January 2022, they’ll need to ensure that any benchmark they’re using for a product would need to be approved for use in the EU. This may become even more complicated after BREXIT because indexes based in the U.K. may be deemed third country indexes.
I believe there’s going to be a lot of cooperation between the asset management community and the index provider community to make sure indexes are approved for use in the EU. For now, however, I don’t believe all small and midsize asset managers in the US and Asia fully comprehend and appreciate how it is going to impact them. Many managers think, “It’s regulation in Europe, it doesn’t impact us”. But the European benchmark regulation impacts any index or benchmark that is used in the European Union for any purpose.
BILD: Maybe we can close with your take on active versus passive, especially in light of the volatility this year and the ongoing debate about how to invest?
Rick Redding: There are good active managers out there that provide value, and IIA does not advocate that the only way for investors to invest is through index-based products. Many sophisticated investors use both approaches in tandem; there is no single investment strategy that works for all investors.
Today, many institutional investors years ago have now moved more of their core portfolios to index-based strategies, but where they try to outperform, they’ll still look at active forms of management. I think a lot of them have proven this combination to be a pretty effective strategy.