How index providers decision to postpone index rebalances impact investors and ETFs

Dan Barnes Welcome to ETF TV, I’m Dan Barnes. With me is Deborah Fuhr of ETFGI, and Tobias Sproehnle, Moorgate Benchmarks. Today, we’re going to be talking about what’s been happening in the ETF market over the past month.

Deborah Fuhr So it’s been an exciting month, clearly with a lot of volatility, we have seen ETFs bust a lot of myths, where people were concerned that they wouldn’t work well when there was volatility or when there was large inflows and especially outflows. And we’ve seen that happen both in equity ETFs and fixed income ETFs. So we celebrated the 30th anniversary of the listing of the first ETF in Canada, in March. We also saw that globally we actually had net inflows of 20 billion dollars going into ETFs, primarily into equity products, outflows from fixed income and money going into, primarily when we think about commodities, physical gold. But what we have noticed is many people have been surprised that a number of the indices are not being rebalanced and some people don’t even know that, that’s happening. So I think what’s an interesting topic to talk about is, who decides this and why and how and what does it mean for investors?

Dan Barnes Tobias, can I ask you, typically, what’s the process for rebalancing that index providers go through and what’s changed?

Tobias Sproehnle Index providers generally adhere to a set of very comprehensive rules and methodologies. Some changes and the rebalancing they’ve made to indicies have been routine and therefore, as expected or justifiable in response to any sorts of predictions. So they’ve always adapted indices to ensure that they remain accurate barometers of whatever economic interest they’re designed to measure. What has happened now over the last couple of weeks is that, against the backdrop of daily changes in asset prices hitting almost unprecedented levels, some providers have decided to delay or cancel periodic rebalancings altogether. So S&P was the first one out of the block in the equity indicies, but several providers followed, who delayed their rebalancing or considered rebalancing altogether. Now, the rule book stipulates that this is a decision they’re absolutely entitled to make at that discretion, but it can be hugely damaging, particularly if unexpected.

Deborah Fuhr And it probably also means that some of the investors are now investing in products that may not be following the mandates, right? So it could hold securities that no longer fit within market cap rates, and also equal weighted wouldn’t be equal weight any longer.

Tobias Sproehnle Exactly. Yes, that’s absolutely something which is the big downside here, and that’s something which regulators should also be concerned, because by delaying index rebalancings, we might have a situation where the indices and therefore the index-linked products don’t really 100% reflect the economics of the underlying. I personally think what we’re witnessing at the moment isn’t really totally unprecedented or even unexpected. We have a situation where it may be exceptionally difficult to trade with conviction right now, but it doesn’t mean that markets are not properly pricing assets, which is typically a condition in index provider rule books, which would justify any delay or cancelation of a rebalancing. What we’ve seen across equities and fixed income is really that markets have stayed open, trading has occurred, and assets have continued to be priced. So the decision to delay or cancelling, the index providers decided they knew better than the market. And we think it’s a significant blurring of roles, as you could argue, that index providers are actually playing a very active investment decision role at the moment.

Dan Barnes Can you give me your perspective on who might be brought in to consult about this issue? Clearly, there are regulators, investors, index providers themselves, and fund managers. But who’s going to make the decision on this?

Tobias Sproehnle That’s a very good question, and I mean, relying on discretion is really not a sustainable strategy for index providers’ decision making in the long run. I think we need quantitative metrics and really standards to help determine when markets have turned exceptionally and under which circumstances applying discretion is the option. And if and when a decision is taken to delay or counter the rebalancing, it should be done by providers in an organized and ideally, in a coordinated way so that correlations and tracking errors remain in place.

So I think first and foremost, what should happen is, there should be an industry wide debate to really define the triggers for this, to define procedures for this, and also to really have a look at whether the transparency and communication around this process is the right one. The other thing which could happen is regulators are more and more looking in the indicies with the arrival of the European benchmark regulation. Our chief regulators need to play a role here as well.

Deborah Fuhr End investors, too, right? Because you have a lot of investors who tried to trade around index rebalances, and that’s part of their strategy. So I’m sure they’re going to have a view on this.

Dan Barnes Well, Tobias, thank you very much for your time today. It’s been really interesting.

Tobias Sproehnle Thank you. It’s been a pleasure.

Deborah Fuhr Thank you.

Dan Barnes I’d like to thank Tobias Sproehnle and Deborah Fuhr for their insights into the ETF markets today,  and of course you for watching. To catch up with our other shows, go to ETFTV.NET and TRADERTV.NET.

Published on April 21, 2020