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The Go-Between: Index firms’ balancing act

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By Waqas Samad, CEO, FTSE Russell

One of the least understood aspects of the index provider’s role is their position regarding inclusion of securities in indexes used by the community of investors, regulators and other market participants.

Index providers’ classification decisions have been compared – by others outside this company – to papal conclaves, where cardinals electing a pope are locked in the Sistine Chapel until a decision is reached. Smoke billowing from a chimney is the only sign of the ongoing decision-making process.

The inference is that the index classification process is opaque. That’s a serious charge, as any index, regardless of asset class, should follow clear, coherent rules within a construction framework that reflects the realities facing participants in the international capital markets.

The world increasingly demands openness in corporate decision-making processes, and that is how we operate. For example, we have just announced a country classification process for our fixed income indexes that we believe will deliver the equivalent levels of transparency and dialogue to our equity classification process.

That process is built on a transparent equity country classification process that we followed when concluding that we would be admitting China A Shares to emerging market status, or when Poland’s equity market transitioned from emerging to developed market status. FTSE Russell’s flagship global equity index series, FTSE GEIS, now covers cover 48 countries and over 98% of the world equity market, from a universe of 23 countries and around 70% of the global equity market’s capitalization 30 years ago.

The process demands engagement with both regulators and investors. That engagement works best when there is a framework – a structure that they can work with, and one that tries to encompass the broad set of issues that investors face when investing in local markets. Engagement should be fruitful and with a purpose that is independent of other considerations.

Large investors need to communicate their wishes for reforms in technical areas like local securities settlement mechanisms, or foreign exchange and derivative market liquidity to local financial regulators. Local finance ministries and central banks may want to gain reassurance regarding the nature and volume of the investment flows that may follow index changes.

And the rules should allow for a governance structure to resolve tricky questions, such as those affecting index inclusion or exclusion, in a fair, consultative and transparent way.

The index firm has to play the role of a neutral arbiter in these communications and can only do so by being as transparent as possible about the framework and processes involved; helping to develop a consensus view when investors’ views diverge, and to allow transparent communication to the market when the time comes.

Index providers are the bridge between several constituencies, and we have to recognize the interests of different market participants will often diverge. So we have to agree on changes to benchmarks in a thoughtful, transparent and consultative manner, and we have to continue to strive to meet investors’ and regulators’ legitimate desire for transparency. We also need to continually reflect on the issues investors and regulators raise with us, and recognize when our processes need to change as markets evolve.

 

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