December 5, 2018
From time to time, ETF BILD has the opportunity to discuss a variety of issues and topics with prominent individuals in the ETF industry. In connection therewith, we seek comments from our readership resulting in a full and thoughtful discussion around the issues and topics vital to the ETF Industry.
Recently, ETF BILD sat down to speak with Rick Redding, CEO of the Index Industry Association (IIA). We talked about the state of indexing and various regulatory and business issues. Below is a summary of the highlights from that discussion.
ETF BILD: Will the index industry become regulated?
Redding: Index regulation has already occurred in Europe. The European Parliament approved the Benchmarks Regulation, which is a set of rules governing the use of indexes as benchmarks. This regulation has global implications for index providers, not just ones in Europe. It is possible that a new ETF regulation in the United States may be next. The SEC recently has been sending information requests to ETF sponsors of indexes. Often such requests are a precursor to rules.
ETF BILD: Are the costs of compliance and other factors driving consolidation in the index industry or causing index providers to partner with exchanges, data providers and other types of companies with deep pockets?
Redding: I do not necessarily see a wave of consolidation coming in the index industry. Rather, the alternative is for index providers to partner with companies in related industries. For example, there are many synergies with index providers and financial data providers, so those types of consolidations may make business sense.
ETF BILD: Why have intellectual property rights become important in the index industry?
Redding: Index providers naturally want to protect their intellectual property rights to the index methodology. Without the protection of their intellectual property, no provider would ever create new indexes and that would deprive investors of innovative products and competition. Some asset managers are creating their own indexes instead of licensing indexes from the large index sponsors. If a manager’s self-indexed ETF becomes successful, the methodology behind that index becomes valuable to the manager.
ETF BILD: Will new regulations such as the proposed ETF rule potentially make it more difficult to protect index methodology?
Redding: The more information an arbitrager has about an index that an ETF is tracking, the better it is able to trade the ETF’s shares to exploit any difference between the ETF’s net asset value per share and market price. The SEC emphasized the importance of such arbitragers when it proposed the ETF rule, which conceivably could require the publishing of more information about an ETF’s securities holdings. The SEC recognizes the need to protect the underlying intellectual property but also properly wants to have adequate disclosure of the underlying securities.
ETF BILD: You noted the trend for some asset managers to create their own indexes. Does this create conflict or other issues?
Redding: Managers naturally desire to sponsor ETFs and other products that track indexes that perform well as the performance of a financial product is always a key factor in its ability to attract investors. This creates a temptation for an asset manager to put more weight on designing an index that will perform well and less emphasis on making sure it is a useful benchmark. We have seen some providers of so-called smart beta indexes and products struggle with this issue. IIA believes separating the functions provides the best protection for investors.
ETF BILD: How can these conflicts be addressed?
Redding: Such conflicts can be avoided by separating functions: the product creation for investors, index design and administration. The asset manager licenses with a third party for its index or to design an index.
ETF BILD: More and more ETFs that track complex indexes are being introduced each year. Are these indexes too complicated for investors to understand?
Redding: Indexes with multi-variant methodologies and complex rules certainly are on the rise. It can be more difficult to understand their methodologies and why products that track these indexes would be beneficial to the average investor’s portfolio. Nevertheless, these products can be valuable to certain investors, such as institutional investors, who have the knowledge and experience to understand the products and how they can enhance their portfolios.
Direction of the Index Industry
ETF BILD: Where is the index industry headed, especially in terms of key issues?
Redding: Issues related to indexing fixed-income securities are going to become more important as more ETFs and other financial products seek to track fixed-income indexes. Because bonds do not trade on trading venues like equities do and, in many cases, infrequently trade, there are far greater challenges with valuing the bonds that make up a fixed-income index. Information about certain bonds are not as readily available and investors desire better transparency in how they are valued and priced. As these processes become more transparent, it will be easier to develop indexes that more accurately benchmark various types of bonds.
ETF BILD: Will you see more and more custom indexes?
Redding: I believe so, especially with respect to ESG investing. More and more institutional investors are demanding benchmarks that exclude certain types of securities. For example, they may know that an industrial company in a particular ESG index is a low carbon dioxide producer, but it also employs processes that pollute rivers and streams and has a poor record of diversity. As a solution, such institutional investors could seek out index companies that can design an ESG index with multiple screens tailored to their particular circumstances, beliefs and needs.