Hartmut Graf, CEO of Stoxx, talks to Emma Dunkley about the importance of index transparency and the need for innovation to access new asset classes
Indices are one of the key building blocks for ETFs, serving as the underlying component providing access to markets. When considering which regions, sectors or themes to tap through ETFs, many investors base their choice upon a range of factors including total expense ratios, tracking error, and counterparty risk.
Yet as Hartmut Graf says, understanding the underlying index is paramount when comparing ETFs. As the largest provider of indices underlying ETFs in Europe, Stoxx acknowledges the significance of index transparency and the need for investors to have sufficient understanding as to how indices determine ETF performance.
Graf says: “It is important to provide independent and transparent underlying indices, to ensure high quality ETFs so investors can fully understand how they work.” He added there is a joint role for index providers and ETF product issuers to find the most transparent and efficient market access.
Around one third of European equity assets are linked to Stoxx indices and Graf says Stoxx is expanding its distribution, while widening its index range. This development is part of Stoxx’s plan to become a global player, following its split with Dow Jones in December 2009.
In line with this view, Stoxx’s aim is to continuously create improved and enhanced indices. “There is still plenty of room for further innovations and improvements in the indexing space. The optimised sector indices we created are established with that in mind. These have been successful over the last year, demonstrating there is high interest in these new concepts.”
Last July, Stoxx created a family of Optimised Supersector indices based on the Stoxx 600, which were licensed to exchange-traded product provider Source to underlie 18 ETFs. The indices are unique in that they take into account the ability to borrow a stock in the stock lending market, and then adjust the index constituents accordingly. The optimised characteristics of each stock are determined by analysing the equity turnover value and the availability to borrow. The Stoxx Europe 600 index constituents are then ranked based on these two factors.
“Our newer market quartile indices follow the same sort of direction as the optimised index concept,” says Graf. “With other indices, we try to make new asset classes better tradable. One of our key areas of expansion is in the volatility product space.”
Some critics argue that too much innovation can over- complicate ETFs, diminishing the fundamental attraction of these funds as simple and transparent. Graf says: “Innovation is an integral part of the financial industry as a whole and product development in the ETF space. On the other side, there are different levels of sophistication among investors and it’s important to find the right concept for each investor.”
Education is essential
As well as index transparency, education is vital in ensuring investors understand innovative index concepts and the risk-return involved. Leveraged and short indices, for example, are seemingly simple and yet if used in the wrong way can have a severe impact upon investors. Graf says: “An understanding of the underlying concept is arguably the most important point. It doesn’t matter whether you have five basis points difference in ETF management fees, for example, because the major performance contribution comes from the index.”
Understanding the concept of the index will become even more important as ETFs expand across the European retail markets. “The overall ETF topic gets a lot of traction from press and media,” says Graf. “This is especially true after rising concerns over the past couple of years with respect to counterparty risk. For this reason, ETFs are one of the most practical vehicles for retail investors, although it still needs more time.”
As more ETFs come to market, the need for innovation in creating underlying indices grows. Graf says: “The number of ETF providers has increased over the last couple of years with standard licences on traditional benchmarks. They are starting to differentiate from each other, and for that reason, they need to have new indices to provide a different set-up for their offering.”
Graf explains the European ETF market largely differs to that in the US, where indices are typically licensed to a smaller number of ETF providers. However in Europe, some of the ETF providers only have local or limited distribution, therefore granting multiple licences ensures indices are present across countries. Graf adds: “This is one of the key drivers as to why you see multiple licences in Europe.”
Nonetheless, despite the prolific licensing of traditional benchmarks, Graf says there is demand for advanced indices. He adds: “We need to be able to roll out concepts going beyond the traditional way of indexation, which is necessary because traditional concepts do have their own deficits, to an extent.”
There is a wide range of techniques employed to create innovative index concepts. In the equities space, weighting is one of the main methods, as exemplified by Stoxx’s Optimised Supersector indices and the more recent Market Quartile indices. However, Graf says tradability and accessibility become the major issues to consider for the more exotic equity markets, including some of the emerging regions like Russia and India.
With further innovation in the pipeline, Stoxx continues to seek ways for investors to tap new markets. Graf adds: “We are going to concentrate on making new asset classes and new risks accessible.”
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