|What’s Inside Your Index?|
|21 February, 2012|
Page 2 of 2
When it comes to disclosure, the websites of strategy index providers vary widely and many currently provide little or no in-depth information to the public. Registered users (usually, banks’ direct clients) typically get access to more information. However, as we discussed in a recent article on IndexUniverse.eu (Shifting Gears On Strategy Indices) industry practice is set to change. The European Securities and Markets Authority’s ETF consultation paper, released in January, makes much of the need for additional transparency in strategy indices. Under the draft guidelines the index provider will need to disclose the full calculation methodology, allowing investors to replicate the index. This means that index costs, fees and payout structures will in future be fully disclosed for indices used in UCITS funds.
A more fruitful source of information on index fees and costs is the investment product providers’ websites, where you can find both fund and index-related expenses in factsheets or the fund prospectus. Even here we find that more complex structures, like the JP Morgan/Source ETF mentioned above, don’t reveal all the index costs in detail. In this case a potential investor would need to go to the JP Morgan indices website to find the full information.
In the US market it’s somewhat easier to find the relevant information. If the underlying index is to be used for a US-listed investment product, it should be possible to read the so-called “free writing prospectus” (FWP) on the SEC’s “Electronic Data Gathering, Analysis, and Retrieval” system (EDGAR).
Unfortunately, there is currently no easy way of comparing index expenses between products on a like-for-like basis. It would be a positive step for the industry to provide a standardised measure of index expenses (such as an index ”total expense ratio”), as well an all-in product level figure (or range), which would include both fund and index expenses.
Leveraged And Complex Payout Structures
As mentioned above, the daily index calculation is intended to mirror a fund’s NAV calculation in its treatment of expenses. That is not the end of the story, however. The index may also be structured to include fixed or active leverage or even more complex payout structures.
Leveraged ETFs, for example, may apply leverage at the fund level to an unleveraged underlying index, or track an index that includes a leverage factor in its calculation. In the latter case leverage is an intrinsic part of the investment strategy being pursued and is applied as a fixed multiple of the underlying index’s returns. However, leverage may also be used dynamically in so-called “risk control” indices (here, for example, an index’s exposure to its constituent assets may vary according to the volatility of those assets).
Risk control indices may follow a relatively simple, systematic asset allocation scheme (equal-risk-weighted indices are an example) or may target a set level of index volatility through a process of dynamic leveraging and deleveraging. In its ETF consultation paper ESMA recognises the use of leverage in strategy indices and proposes guidelines to ensure that the mechanisms employed in the index respect the UCITS diversification rules.
It is possible also to “index” a complex payout structure, such as one embedding financial options. Many so-called structured UCITS funds, whether index trackers or not, contain options, and such funds are likely to be classified as “complex” in the ongoing review of the Markets in Financial Instruments Directive (MiFID). At present UCITS are automatically considered as simple products and it looks likely that ETFs will continue to be treated this way.
However, as we’ve shown, complexity and costs can occur both in funds and in the indices underlying them. Hopefully, regulators will consider both fund and index structures when assessing financial products.