Index construction: leading body warns against ‘false promises’

A leading research body has warned against focusing on stronger governance in index construction at the expense of transparency, as it has proven too ‘ineffective’.

The Edhec-Risk Institute’s recommendations on financial benchmarks come in response to European regulator’s consultation papers on the principles that should be used to underpin the creation of indices.

The body cautions regulators against the temptation to trade lower levels of transparency against stronger governance or stricter standards, because the latter have proved ‘ineffective at ensuring good behaviour or protecting the interests they are expected to defend.’

Edhec said as a result, the principles can at best support transparency and at worst ‘exacerbate moral hazard.’

The body said it ‘also wishes to warn regulators against promoting a false sense of confidence by organising or condoning a framework that would give the illusion that conflicts of interest have been dealt with.’

These discussions on governance could pave the way for a regression in terms of transparency for retail funds.

Edhec added it disagrees with the European regulator, Esma, in assuming governance and transparency are interchangeable, and that a lack of transparency could be compensated by an improvement in the rules of governance.

The body also disagrees with Esma’s representation of governance as ‘the high road and transparency as a fall-back solution enabling external monitoring to be carried out in the absence of “sound governance mechanisms.”’

The transparency Edhec advocates allows index users to understand the benchmark and its construction principles.

It would also enable them to independently replicate its track record, gauge the systematic character of its methodology and conduct performance and risk analyses so as to assess its relevance and suitability against their specific goals.