Editor’s Note: This June, the Index Industry Association is introducing a new content stream that highlights the form and function of indexes, and their role in 2020’s investing environment. This blog is a companion piece to our new five-part video series, Index Foundations, which is now live on our Insights page.
Earlier this year, the index world took center stage. As a result of the spread of the COVID-19 virus and its disruptive impact on the world economy, global stock market indexes recorded some of their biggest advances and declines in history. 2020 has seen significant market volatility and even large intraday swings hanging on geopolitical events, the latest bankruptcy filing or growing hope for a potential vaccine. Market indexes have kept score of all of these significant market ups and downs triggered by the Global Pandemic. The question now: will indexes be as important going forward for investors?
And in fact, yes, this is an immense opportunity for our market participants. In recent months institutional and retail investors, hungrier than ever for market insight and context, have benefitted from the objective measures that market indexes provide. Millions of individual investors are curious about what an index can tell them, how they are used as benchmarks, as well as about the exposure and benefits offered by a product linked to an index. Conversely, it’s also a test—both for the community of index providers and to new indexes who grew up during an unparalleled bull market period. Like every vestige of financial markets, indexes’ construction, balancing procedures, and operational management are under a microscope. Their material effect on the markets will be analyzed in the wake of the COVID-19 disjuncture, too.
Luckily, indexes have been built over decades to answer those questions. Today it’s worth declaring the truths and drawing the distinctions that should make indexes safe and effective bedrock for investors going forward.
Indexes Measure – Rather Than Create – Market Volatility
First, as a result of the pandemic, global markets endured an intense period of volatility, particularly in February and March 2020. Inquiring minds have sought to determine where it came from and given their outsized influence on the market, indexes will be at the center at that study.
While some market commentators have claimed that indexes create market volatility, the opposite is actually true. Indexes actually help investors measure volatility, not create it. In fact, there is a strong argument that index-based investments generally act as an anchoring mechanism or “shock absorber” for the markets during times of market stress, due their passive “buy and hold” nature and limited trading activity.
Moreover, indexes underlying some asset classes have brought some illiquid and over-the-counter markets into regulated exchanges. Several studies have shown that hedging instruments based on indexes actually give investors the ability to reduce volatility.
Indexes Don’t Equal Investment Products
Next, for new investors it’s worth understanding what an index is—and isn’t. Sometimes, investors conflate indexes with the investment products themselves—a typical consumer may not know the difference between the S&P 500 index and State Street’s SPY exchange-traded fund. While it is not possible to invest directly in an index, indexes can form the basis for investment products. So it’s best to understand how both of these work and how they fit together.
Product providers work with independent index providers to license the underlying indexes as the basis for investment products such as mutual funds and exchange-traded funds (ETFs). It’s important to note that independent index providers are not asset managers, nor do they trade the underlying component securities. Instead, one of their primary roles in the investment landscape is to provide benchmarks against which asset managers can measure their performance.
Independent Indexes Are Transparent
Furthermore, investment products based on market indexes are built and maintained on a foundation of simplicity and transparency. Unlike many active or “black box” quantitative investment strategies where the methodology is not always fully disclosed, index methodologies are publicly available and market participants are free to review the process for index construction and maintenance.
The Index Industry Association’s Best Practice guidelines demand that index providers clearly document their methodology, provide updates on any material changes, periodically review their methodologies and allow market participants’ engagement to provide feedback.
Indexes Don’t Hinder Price Discovery
Fourth, as index-based investing has grown significantly in recent decades, concerns have risen that this rise hurts price discovery and market efficiency. In reality, indexing plays a relatively small role in price discovery.
According to a recent research note by Vanguard, price discovery is primarily driven by active market participants such as high-frequency traders, market makers, hedge funds and individual investors while most indexing strategies have low turnover and trade at the margins. Their distortion effect on pricing is therefore minimal. For example, Vanguard’s report quotes a trading volume figure of approximately 1%, well below the widely quoted 5-7%. Meanwhile, indexes that are the basis for futures products are widely acknowledged as promoting price discovery.
Independent Indexes Have a Strong System of Checks and Balances
Finally, governance is an important aspect to consider when it comes to any data or investment product. Indexes are administered according to transparent methodologies created by index committees. Moreover, many firms also work with external committees of market participants who advise on important index issues. Indexes based on regulated, transactional data are flagged by market participants if an errant price is included because arbitrageurs and high-frequency traders will notice immediately.
The IOSCO (International Organization of Securities Commissioners) Principles, a global set of requirements for all index providers that ensure commitment to the development of benchmarks with the highest levels of transparency and integrity, must be reaffirmed each year. In addition, global index providers are regulated under the EU Benchmark Regulation, a regime for benchmark administrators that ensures their accuracy and integrity. The Index Industry Association’s members must also follow the standards outlined by the IIA Best Practices.
With all of these characteristics built in, indexes are extremely useful tools for investors. Already important before the pandemic, market indexes will be even more important coming out of it as investors seek simple, objective and transparent market measures to help make sense of where the markets have been and where they may be going. Market indexes provide the perfect roadmap as investors attempt to navigate the “new normal” we are in today, and whatever “normal” we may encounter in the future.