July 23, 2007 8:23 pm

Not every index wants to be benchmark

For most investors, a handful of long-established indices – the S&P 500, the DAX 30, the FTSE 100 – represent the extent of the index universe. But investment banks and specialist index companies are churning out indices at a rapid rate.

In part, index development is driven by banks’ desire to measure and promote their investment strategies. Also, fund managers are keen to show investors that their money is being invested in the most profitable way.

“In my world we launch a new index every six weeks,” says John Butler, head of the index strategies group at Deutsche Bank. “We try to populate the risk spectrum so every aspect of risk that is anything to do with interest rates is covered.”

Last month, Deutsche came up with the first of a series of indices to give investors access to its equity research analysts’ shorter-term investment ideas. An index for hedge fund returns had launched in May; fixed income and foreign exchange indices in March.

Standard & Poor’s, which has a large index business, reckons to calculate 1m indices a day across 78 product families. MSCI Barra says it has 80,000 indices.

It is not difficult to get to these large numbers with subsets of large global indices, says Ted Niggli, head of MSCI Barra’s equity index business. “We take the all-country world index and slice it by country, region, sector and market capitalisation. You quickly get a Rubik’s cube of indices.”

“A bank may decide that calculating indices is not a strategic function and it will outsource it to us,” says Chris O’Brien, European vice-president for business development in S&P’s index services team. “Or they may ask us to do the back-end calculations for reasons of cost efficiency. Having a third party do the calculations confers legitimacy and helps them jump the regulatory hurdles.”

But many banks devote considerable resources to creating proprietary indices that reflect their investment strategies and products based on these strategies.

This surge of index creation reflects the increasing sophistication and liquidity of the world’s markets. Indices have become means to outperform, providing alpha. “When a bank can prove that their trading strategy is providing alpha they will make it available to third parties,” Mr O’Brien says.

Deutsche creates indices in-house, says Mr Butler. “We regard them as proprietary indices because we have developed an alpha-generating trading strategy that did not previously exist. The index is something that reflects our intellectual capital.”

The point at which a proprietary index becomes a generic benchmark can be hard to spot. Becoming a benchmark reflects a general acceptance of a particular index, and their highly specific strategies means that many will never gain wide appeal.

Deutsche is keen to promote its new currency return index as “the first investable benchmark for currency markets”. Jason Batt, head of forex index products, says: “People are not so familiar with foreign exchange as an asset class. We realised that to gain penetration we had to step back from proprietary indices and do something that was very simple and generic.”

The new index replicates the most widely employed forex strategies – carry, momentum and valuation – and combines them in a non-discretionary, rules-based index. A proprietary index, by contrast, would introduce more options.

For example, an index aimed at maximising returns would not, in current market conditions, include an element shorting the yen. But this is included in the Deutsche index to reflect the strategies chosen.

Creating benchmark indices can pay off in terms of generating additional trading volumes as well. Growth of the credit derivatives market was boosted in 2004 when two rival indices, backed by competing groups of banks, agreed to merge. Investors had been uncertain which index offered the best liquidity and held back from trading.

Index creation can be a long and costly process – up to two years when a radical new asset class is being included – and there is no guarantee that the resultant index will catch on.

If an index does gain acceptance, it generates new business. An index that demonstrates it can provide good returns will be used as the basis for a range of new products including investment funds, certificates, notes, swaps and options.

If these products are sufficiently popular, their use may be licensed to other banks and that earns fees for the originator.

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