FTSE Russell: Volatility is now an indicator of return

In the second part of an interview, Gareth Parker (pictured), senior director, index research, design & development at FTSE Russell, talks about smart beta, fixed income, regulation and what comes next in the index market.

In what areas do you think FTSE Russell can provide a differentiating factor? What growth areas are you looking at?
The combination of the expertise across the market will allow us to understand different investor needs and deliver solutions even faster than we have done in the past. Smart beta is one area where we are seeing increased activity. We expect it to continue to be a dynamic space as different providers attempt to build new strategies and different ways of combing factors. The various approaches to traditional cap weighted indexes have come together over the last 20 years, and I’m sure individual Smart beta strategies will go through the same process.

Smart beta has been driven by a sudden understanding that building a portfolio with a pure market cap weight approach is perhaps not always the best strategy. Index investing is often cheaper than many alternatives however this does not mean that market cap weighted indexes are always appropriate. There is always a need for a market performance measurement, but Smart Beta strategies can help investors address some of the issues related to more standard indexes such as correlation between markets.

FTSE Russell published the second edition of our Smart beta survey this year, which found that Europe is ahead of the US in the use and development of Smart Beta strategies, and we are now focusing on the next phase including the combination of factors. This allows market participant to address the tendency of individual strategies to see significant drawdowns. Our research also highlights the different trends surrounding the use of smart beta strategies. For instance, the survey shows that European investors like the more mathematical and algorithmic strategies such as minimum variance or low volatility.

Is the smart beta bonanza a reflection of failures in active management?
Active managers will continue to be needed to establish prices. It is fair to say that that segment of the market could diminish in size, but then we may reach a point where active management grows again if price discovery starts to flag.

Are there suitability issues with smart beta strategies?
This is determined by what you are trying to achieve, and the best way of doing it. The simplest way to invest in passive management is by using market cap indexes. However, some investors want their portfolios to contain other strategies to generate income over time. This could be by addressing under exposure to volatility or another factor that might be used to boost the return in a portfolio. Some factor indexes are relatively complex but eventually the general approach will start to be used by retail investors. Advisers are being educated and now understand how they can access these strategies via different products.

Risk control has become a trend in the structured products market in recent years. What’s your view on those indexes?
Risk control is another great example of how index providers can develop an idea originated elsewhere. Volatility is an overlay factor that would work with any index. Volatility has become an indicator of return, and if volatility spikes then investors may want to be able to move into other asset classes. The idea of avoiding risk by avoiding volatility can be addressed in different ways, but market participants need to be aware that a low volatility index (a return-led strategy) is different to a minimum variance index (which provides exposure to assets with low volatility and allocates weightings based on it).

Are there any issues around capacity and liquidity in smart beta strategies?
If market participants want to take price out of the equation because they do not think the market is efficient enough, then they can use an equally weighted product. However if you put the same amount of money into the two opposite ends of the FTSE100, there is a risk of having a price squeeze at the bottom end and the opposite at the top end. Capacity is an issue and could potentially be a risk in the future if everybody is investing in smart beta indexes as opposed to market cap indexes. FTSE Russell has already looked at putting capacity constraints in our indexes and running dummy trades, which allows us to spot and address any potential issues.

Why is fixed income getting so much attention from index providers? And what other areas you think will drive sales?
This is increasingly an area of focus for FTSE Russell. There is already significant assets under management linked to FTSE gilt indexes, but we want to do more. Multi-asset and multi-factor strategies are also gaining increasing momentum. These approaches can help investors address volatility issues. For example, an investor looking for exposure to volatility should perhaps not be constrained to equities. FTSE Russell’s capabilities now allow us to look at volatility on commodities or fixed income bonds.

Fixed income is a big sector, and the way these indexes are being constructed is changing. Instead of building an index on the back of the issuance of bonds, index providers have been looking at other methods such as GDP weighting or equal weighting.

Has regulation impacted FTSE Russell in any way?
The advantage index providers have over other financial services firms is that they are transparent and objective. FTSE Russell has a number of committees that look at the composition of our indexes and the methodology that governs them. We support the view that regulators should ensure that benchmark providers are not subject to conflict of interests. Regulation can only be potentially problematic if it limits the market’s ability to innovate.

I have a fundamental belief that education is the key to address many of the problems we have seen in the market over the years. It is important that the public understands the difference between passive and active investing, the benefits and downside of index investing and the use of different strategies to achieve different objectives. The more market participants can do around education, the better.

FTSE Russell’s indexes must meet a number of requirements around transparency and liquidity. Suitability is also paramount, as a product linked to one of our indexes may not be appropriate for an investor with a low risk profile but may be the right product for another investor with different aims.

Where do you want to be in five years?
FTSE Russell is well positioned to be successful in the index-linked products segment, and with the combination of the two businesses capabilities we hope to become the biggest global index provider.

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