The free market and the ballooning number of indices

If there is one thing bound to scare the horses in the world of investment it will be a headline figure or number that ‘just doesn’t feel right’. Numbers matter and in the world of investment, any number which somehow feels somehow hard to comprehend will immediately arouse suspicion.

Such is the case with the news released late last year from the Index Industry Association (IIA) which showed there were over 3.7 million indices globally, 12% up on 2017.

This proliferation can be read two ways; for the industry the bloom of indices – driven by the rise of ETFs as an investment vehicle – is a measure of their success. For the critics, the profusion is a house of cards built as it is on the back of a number of actual financial instruments, whether equities, bonds or other assets, that is measured more in the thousands.

“It shouldn’t surprise anyone that there are more indices than underlying securities,” says James McManus, head of research and investment manager at robo-adviser Nutmeg. “Given indices are created by weighting the underlying securities in different ways, the number of combinations of securities will far exceed the number of securities themselves.”

This theme is taken up by Timo Pfeiffer, research and business development at index provider Solactive who points out that indexing bears resemblance to other industries such as the car industry where there are thousands of variations based around some basic models.

“Translating this concept to indices, you can have one standard benchmark or index – let’s say one that tracks US large caps – but then you have this very same index with different ways to reinvest dividends at different reinvestment rates, for example, gross return, net total return, and price return,” he says.

Add in currency versions of the same index and it can be seen how the total number soon multiplies and while ETFs are one area of finance in need of indices to benchmark against, these are far from being the only use cases.

“Taking a look at portfolio managers, hedge fund managers, or traders at banks; all of them need specific indices of markets they are operating in, to benchmark their strategy,” Pfeiffer says.

“Additionally, a large part of the indices is traded within the institutional marketspace between banks and asset managers, meaning that the performance of a certain portfolio is often measured against a certain benchmark. The easiest way to measure this performance is to set up this portfolio as an index.”

Oliver Smith, portfolio manager at IG Smart Portfolios suggests that the proliferation of indices represents market forces at work.

“Investment professionals love to measure performance, so in this respect large numbers of indices are very useful,” he says. “With a click of a button we can see exactly how one sector has performed relative to another, or how BBB-rated bonds have performed relative to CCC.”

Feeding the ETF beast

This also goes for the world of ETFs where product providers are on the search for unique products with which to distinguish themselves in an increasingly competitive marketplace. It results in many custom indices where, he suggests, it is hard to obtain the full methodology and factsheets.

“The details aren’t always readily available,” he says. “In fact, many index providers still do not do a good enough job of making index data publicly available at no cost. Even as an institutional investor, we are often faced with a challenge to locate index data, methodologies and back history for the indices underlying ETF products. The volume of indices available doesn’t help this.”
If providers sometimes struggle, then that goes double for the consumer who can often be discombobulated by the sheer choice of products arrayed in front of them.

“It’s very difficult for retail consumers to understand the differences between many indices, without access to institutional quality tools,” says McManus. “There is less of a focus on index education and less index information available from ETF providers, with their content typically focused on the ETF product itself.”

Moreover, as Smith says, some of the new products are based off “more and more spurious indices.” “For example, consumers buying factor-based ETFs will likely find that the return they get is not too dissimilar to a market cap index, and the correlation very high. They may find paying low fees for a core index is more sensible in the long run, rather than being tempted to market-time factors.”

Other suggest, though, that the proliferation of indices – and the ETFs that go alongside them – is innovation at work and as such it should be applauded. “I may not like some of the indexes but index providers are innovating and coming up with new ideas like ESG/SRI indexes, female empowerment indexes, smart beta indexes and more specific bond indexes,” says Peter Sleep, senior portfolio manager at 7IM. “They are all meeting customer demand.”

The data from the Index Industry Association (IIA) proves as much with the most dramatic increase coming from environmental, social and governance (ESG) indexes, which grew 60 percent in the total number of indexes year-over-year.

The growth and innovation in ESG, Factor and Smart Beta indexes over the past year “has been impressive,” said Rick Redding, chief executive at the IIA. “While these areas still represent a small portion of the total index landscape, investors are demanding more choices and as a result, providers are creating new indexes where they can offer more targeted exposure.”

Given this desire on the ESG and smart beta front for more differentiation, Sleep predicts the proliferation of indices is sure to continue pointing out that on ESG “there is no limit” to the exclusions that could be included in any given ESG or SRI index.

All of which means that the current figure of 3.7 million is highly unlikely to be a high-water mark. “The variation possible for ESG/SRI indexes is endless,” concludes Sleep. “As a result, it is easy to see the proliferation in index funds to continue or even accelerate.”

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