In March, as equity market volatility roared higher and credit markets locked up, some of the world's largest index providers took unprecedented action. Others did nothing.
Despite tomes of rules and methodologies that are meant to guide index activity such as rebalancing and reconstitution, the index industry's response to the COVID-19 pandemic was handled largely on the fly, according to multiple industry participants.
"No one had a COVID-19 playbook," said Steve Berkley, chief executive officer of Bloomberg Index Services Ltd. in New York. "We wanted to make a decision that was relatively straightforward and understandable."
For the Bloomberg Barclays Global Aggregate and U.S. Aggregate Bond indexes, that meant "temporarily suspending the exclusion of bonds falling below one-year to maturity," representing 1.13% of the market value of the bonds in the global aggregate index and 0.89% of the market value of the bonds in the U.S. index, according to BISL.
"There's a governance process in place, and several layers of approval," Mr. Berkley said, "and ultimately it comes down to what's the right thing for the market."
But the luxury of that view is largely one of timing and circumstance. For example, MSCI Inc. conducted its latest index reviews in February, whereas S&P Dow Jones Indices, FTSE Russell, ICE Data Indices LLC, the Center for Research in Securities Prices LLC and others all had to tackle the subject of index rebalancing as their largest clients — asset owners, asset managers, custodians and exchanges — pivoted to working from home.
Well-functioning markets were called in to doubt. Opening and closing equity auctions were threatened by stock exchange circuit breakers, and chatter about short-selling bans or even a market holiday was prevalent.
"The operational risk and operational volatility created the potential for large dislocations and outages," said Rodney Comegys, global head of the equity investment group at The Vanguard Group Inc. "Our primary concern was not about market volatility or cost — it was more expensive to rebalance in 2008, for example — but the real issue was the possibility of not getting the trades done at all."
Ultimately, several index providers decided to postpone March rebalances to April for some products and cancel them altogether for others, including widely tracked S&P country, industry and sector benchmarks, picking back up with their quarterly schedules in June.
However, other index providers — including Morningstar Inc., QONTIGO GmbH, Indxx LLC, Solactive AG and others — made no adjustments, even for indexes with a March rebalance.
"As indexes moved from a tool for benchmarking to the backbone for financial products across the asset management industry, the world of passive has become quite active," said Michael Venuto, chief investment officer of ETF issuer Toroso Asset Management, New York. He highlighted consultations on rule changes such as the move to float-adjusted market-cap weighting or how to account for companies with super-voting share classes in broad-based equity indexes.
But rarely have index firms found the need to consult their clients so quickly and informally.
"Not everyone was on the same side," BISL's Mr. Berkley said. "In fixed income, it came down to credit vs. rates and what shapes your world view."
To observers outside the index value chain, a rebalance looks like an instantaneous event, occurring at a point in time based on the data at that time. In reality, a rebalance is a multiweek process in which the index provider measures the market and available constituents, then communicates projected adjustments before publishing the final figures when the rebalance is effective.
The rest of the index ecosystem, particularly large asset managers tracking the indexes, evaluate their own path to rebalancing efficiently without sacrificing their passive mandate. For ETFs, this includes market makers who facilitate the wholesale exchange of underlying securities for ETF shares and vice versa. It's also a money maker for quantitative hedge funds and programmatic trading desks.
The ad hoc and mixed response from index publishers in March highlights the variability in both methodologies and approaches to the marketplace. Some stood their ground (rules are rules) while others were more accommodative.
And while most methodologies across platforms include language related to market closures, none had contemplated scenarios of extreme volatility/limited liquidity or the operational challenges faced by their investing clients. Following the events of March, expect index providers to re-evaluate how they handle index data and operations, including snap consultations, in light of extraordinary events.
