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Self-Indexing: Not as easy as it looks

By: Susan Quintin, managing director, equity index product

As passive investing has captured significant assets and mind share among investors, indexes have become firmly embedded in the investment process. So it should come as no surprise that as investors have grown more comfortable with index-based investing, the complexity of developing and managing indexes remains underappreciated in some pockets of the industry. In turn, the industry sees more asset managers considering self-indexing as a means to lower cost despite the fact that index costs are typically a small portion of a fund’s expenses.  

With self-indexing, an asset manager maintains ownership and control of the index and the related intellectual property (IP). As asset managers race to bring unique IP to the market in the form of index-linked products, each asset manager is addressing the indexing component differently, and often with a mix of self-index frameworks—on one hand, outsourcing index calculation and governance while insourcing all components of index calculation and governance via an in-house index unit on the other hand.

However, assuming the role of an index provider is something that should not be taken lightly. Running global indexes in real-time within a regulated environment is not as easy as it looks. Do you have the right mix of people with index and data expertise? Are you willing to invest in data, infrastructure and governance? Are you able to achieve a desirable scale and profit margin to deliver cost savings to investors? What is your risk appetite related to brand and investor impact?

There are no easy answers to these questions, which is why so many asset managers and investors value and trust long-standing index providers like FTSE Russell. Here are my top three key considerations to ensure a robust index construction process and output:

  1. Strong data management process that delivers accurate and reliable input data. To begin with, the creation of an index requires building an environment of data collection with customized software to automate functions. The sheer volume of data required for even a "simple" broad market index is staggering. Our universe consists of over 80,000 companies with about 100,000 securities and over 230,000 listings. This translates into hundreds of millions of data items processed per year, which is the number of fields we extract, transform and turn into some meaningful data for researchers to review. All of this data requires additional infrastructure so it can be stored, retrieved and, most of all, deemed accurate and reliable. 
  2. Index expertise to balance real-time reflections of the market with investability and turnover criteria. Indexes must be periodically rebalanced for a variety of reasons to ensure an accurate representation of a market and its size and style segments. Indexes rebalance at different times following different methodology. For example, every June the Russell US Indexes are rebalanced following a very precise schedule. Similarly, to ensure that the classification of markets within FTSE’s global benchmarks remain accurate and up-to-date, FTSE Russell works closely with both the institutional investor community and domestic market authorities to review the classification status of countries in our global benchmarks into different classifications: Developed, Advanced Emerging, Secondary Emerging, or Frontier. Again, these vital processes and numerous other crucial maintenances of indexes require substantial resources, infrastructure and methodology.
  3. Comprehensive governance framework that meets evolving regulations. Creating and managing a governance framework is a core competency for index providers. FTSE Russell has built a comprehensive framework and infrastructure that we describe as having three lines of defense. These combine specialist decision-making bodies with members drawn from first line executive management, an oversight committee with members drawn from second line (risk and compliance) and third line (audit) management, supported by a set of independent external advisory committees formed of market practitioners with specialist expertise on benchmark methodologies, input data and the underlying market.

As with anything done well, it looks really easy from the outside. That makes it tempting to bring the entire process in-house. However, by focusing on their core competency—unique IP and asset management—and outsourcing the management of indexes to a proven provider, asset managers will access greater scale, data and governance. At the same time, they will avoid potential conflicts of interest and lower their risk of an error to their firms by maintaining an arms-length relationship with the index provider. 

 

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© 2018 London Stock Exchange Group plc and its applicable group undertakings (the “LSE Group”). The LSE Group includes (1) FTSE International Limited (“FTSE”), (2) Frank Russell Company (“Russell”), (3) FTSE Global Debt Capital Markets Inc. and FTSE Global Debt Capital Markets Limited (together, “FTSE GDCM”), (4) MTSNext Limited (“MTSNext”), (5) Mergent, Inc. (“Mergent”), (6) FTSE Fixed Income LLC (“FTSE FI”) and (7) The Yield Book Inc (“YB”). All rights reserved.

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