When are index delays justified? Industry standards are vital

In addition to the lives it has claimed and the economic damage it has already wrought, Covid-19 is ringing in a new era in financial markets. It is teaching us that, although markets’ rules and practices have generally held up well so far, there are areas that need urgent analysis and review.

One such area is the set of methodologies and practices governing indexes. Sometimes dismissed as “the basic plumbing”, in reality indexes have a huge impact on the scale and timing of investment flows around the world.

As daily price changes hit almost unprecedented levels in March, a string of index providers, including FTSE, Ice and S&P, decided to delay the next periodic rebalancing – a regular adjustment of an index’s composition that obliges funds tracking the benchmark to fine-tune their portfolios accordingly.

The providers’ rulebooks will stipulate that they are entitled to exercise discretion in this way, but postponing the rebalancing of an index can have significant consequences. Therefore those decisions must be analysed to assess if they were justified and, more importantly, the industry must come up with unequivocal standards to guide any future decisions to delay.

If an index is not rebalanced regularly in line with its methodology, the result for the investor will be “style drift” – less accurate exposure to the securities the index is meant to represent. For example, if some large companies are not added to a large-cap index and some companies that fall in size remain in that index, investors in the benchmark will not be getting quite the exposure they expect. Meanwhile, those using index-based derivatives to hedge positions in other indexes – for example, those using FTSE 100 futures to hedge FTSE All Share exposure – will end up with a less accurate hedge.

The usual process of adjusting the composition of an index is “passive”, in that changes are not discretionary but automatic, based on a pre-existing methodology. And this is linked to another potential problem with the recent rebalancing delays: if investors realise that their “passive” exposures sometimes have a guiding “active” hand, they might start having doubts about index investing – especially if they chose passive asset management precisely because they do not think active managers make good decisions.

Crises will happen again. Relying solely on judgement to deal with them is not a sustainable strategy for index providers

The ability to override an index’s rules was originally conceived to accommodate exceptional circumstances: for example, where the rules do not explain how to deal with a complex new corporate action by an underlying company, or where markets are forced to close.

The market turbulence we have witnessed since the escalation of the Covid-19 crisis is unusual but not unprecedented. Most markets have stayed open, trading has carried on and assets have continued to be priced, removing an obvious justification for putting index rebalances on hold.

There may be other market environments that would warrant a suspension, but these need to be clearly defined. Perhaps providers and various users of indexes could agree on what kind of volatility levels constitute truly exceptional swings. The industry should also come up with rules on the length of rebalancing delays – should they last a week, a month or until market metrics return to normality?

Even before such industry-wide actions are taken, index providers can do a lot individually. They should inform their users of their criteria for delaying rebalancing and provide clear forward guidance in relation to future index reviews. Any decision to postpone index changes should be based on consultation with all stakeholders – including dealers as well as the buy side – even when the timing is tight. Delays should also ideally be co-ordinated with other indexes, so that hedging correlations are preserved.

It is not inconceivable that, if the industry fails to introduce material changes, regulators will extend their powers of oversight over index providers – particularly over those that provide indexes seen as vital benchmarks for investors and pension fund holders.

Crises will happen again. Relying solely on judgement to deal with them is not a sustainable strategy for index providers. So work must begin now on reducing the scope for discretion as much as possible.

Gareth Parker is chief indexing officer and chairman at Moorgate Benchmarks.