What You Need to Know
- The author says the S&P 500 appears to be too high to be the best index for typical clients.
- He says banks now go to great lengths to develop well-tested, trustworthy indexes.
- He contends that some risk-control features may make indexes more complicated but also more valuable to investors.
Custom risk control indexes are non-benchmark indexes with a mechanism to suppress volatility and are commonly used in structured products and annuity products. Yet the various techniques to control volatility are frequently complex and often not clearly explained by the index providers.
Advisors and agents fear that these indexes are potentially over-engineered, and to sell them they may have to deal with compliance and legal risks stemming from potential mis-selling. In fact, one advisor called these indexes “frisky” in a recent discussion with us.
Instead, many advisors and agents opt for staying with the familiar and advocate the S&P 500 index. But the S&P 500 is currently at highly elevated valuation levels and is unlikely to be an optimal solution for end clients. This narrow view also deprives end clients of diversification options for their retirement portfolio — arguably the most important portfolio in their lives.
Diversification requires different investment styles and custom indexes can have an important role to play. So, how to shine a light — and evaluate — the rigorous processes behind the development of the indexes in this still mostly unknown space?
Based on our conversations with advisors, they are skeptical of custom risk-control indexes for various reasons:
- Concerns that an index is over-engineered and won’t perform well in the future.
- Suspicions regarding hidden and/or exorbitant costs and fees.
- In the case of indexes sponsored by banks, a general lack of trust in the banks.
- Concerns that an index is just too complex and people can’t understand it.
We believe that the first three concerns are, largely, a thing of the past. The custom index industry has evolved and matured; the risk-control indexes today are generally well-designed with a high degree of sophistication, rigor and oversight built into their process.
Banks and indexers deploy advanced techniques at each level of index design to ensure their indexes are well-constructed and robust. To test the index performance and avoid over-engineering, for example, the index providers will use an array of statistical tests to analyze historical performance and robustness. They may keep some historical data separate to run an out-of-sample test. They may even launch an index but leave it on the shelf for months to monitor its performance before introducing it to clients. Typically, the bulge bracket banks also have committees which provide independent oversight and approval prior to the launch of a risk-control index.
Banks Want Trust, Not Scandals
A second observation is that, following the Libor manipulation and other scandals, regulators have introduced significant reforms and requirements for entities producing and administering financial indexes — primarily the IOSCO Principles for Financial Benchmarks and the EU Benchmarks Regulation. As a result of these new rules and a strong desire to avoid further reputational damage, banks have instituted very strong and robust controls around the development and governance of custom indexes.