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Custom Indexes and Fixed Indexed Annuities

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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?

How (F)risky?

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.

Today, a bank-built custom index has to be fully vetted by the bank’s legal, risk and compliance departments. The legal team will look to ensure that the index is purely systematic and that the index rules are fully transparent and permit no discretion, absent unforeseen disruptions. The risk team will review questions of tradability, market risk and liquidity. The compliance team will check that any embedded costs and/or fees are clearly disclosed, are appropriate and not excessive, so protecting the interests of the end investors. One bank recently told us that after this stringent process, they still require the approval of the chief risk officer of the entire firm. Finally, there is usually a further independent committee to examine suitability issues of the index for sale into the retail channel.

Boosting Investor Confidence

Most bulge bracket banks outsource the index calculation, using only publicly available third-party price inputs. In this way, investors can be sure that the index rules are being adhered to and they are not disadvantaged. The few banks that don’t fully outsource index calculation often employ an independent third party to check their indexes. One bank which self-calculates its indexes gets its index platform audited by a large, well-known auditor. (We prefer fully independent index calculation and encourage all banks to use this approach.) In addition, banks typically have a separate team, usually in the risk department, to provide oversight and monitor indexes and resolve any unexpected issues that may arise, independently of the sales and trading teams. All in all, custom indexes are now subject to a high degree of rigor and control by the banks, which should provide a higher level of confidence to advisors and their clients.

In some cases, innovation does come at the price of complexity. In the current low rates environment, for instance, structured product and annuity providers have less budget to spend on options as yields are so low. The main determinant of an option price is volatility, hence the need to control volatility as effectively as possible. That, in turn, has pushed custom index providers to become more innovative. They may use techniques such as dynamic risk control or various optimization methods, all of which can help reduce the option premium but inevitably increase the complexity of the products.

Frisky, They Aren’t

A sound investment idea or theme begins with sound research. Banks and asset managers often have large teams of researchers who contribute their cross-disciplinary expertise in the development and design of custom indexes. For end investors, purchasing custom indexes offers them access to a vast pool of intellectual capital and the opportunity to diversify their portfolios from the benchmarks.

Over-engineered and risky? It is in everyone’s interest that an index performs as intended. Undoubtedly, custom risk-control indexes are more complex than benchmark indexes and so a long track record of “does what it was designed to do” performance, with no surprises, is rightly regarded as very valuable. A successful index may be used in multiple products over many years, while disappointing performance will drive investors away from products linked to the index. As an index provider’s revenues depend essentially on the “AUM” linked to its indexes, and while stiff competition is aplenty, there is a strong incentive for index providers to produce high-quality indexes.

Jay Watson Jay Watson is managing director at The Index Standard Ratings, an index evaluation and ranking firm. He was previously managing director and head of multi-asset index structuring EMEA at Barclays in London. He has a doctorate in theoretical physics from Oxford University.

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