— Paul Amery's Blog


The UK’s asset management sector is a classic case of market failure. Its services are allocated in a sub-optimal way, while clients are not shifting their resources to achieve better outcomes.

The Financial Conduct Authority’s (FCA’s) interim report on asset management, released earlier today, demonstrates the lack of effective competition via a couple of charts.

The average ongoing charges for actively managed funds have remained static during the last decade, while those for passive (index-tracking) funds have been declining.



How is this possible? After all, it’s passive that has been taking a steadily rising share of the funds market. Assets in index-tracking funds have risen fivefold in the last decade and they now represent 23 percent of the overall market, says the FCA.

On the basis of the increasing competition from the passive sector, you’d expect the active fund operators to be cutting fees to compete. That they haven’t done so at all is an indictment of their business model. And it’s a very short-sighted one, suggestive of senior executives angling for a last fat bonus before the tide turns, and reminiscent of the well-publicised excesses in the banking sector.

The FCA cites a number of reasons why active managers may have been so immune to competition.

First, there are too many intermediaries between savers and fund managers, and many of those advising on the selection of active managers—whether pension fund consultants, fund ratings services or fund supermarkets—overemphasise the importance of past performance. This facilitates a merry-go-round of managers, lucrative for the intermediaries but detrimental for the clients.

The success of consultants’ own manager recommendations may be poorly monitored, while the consultants increasingly risk conflicts of interest, such as when providing fiduciary management services—getting involved in asset allocation, portfolio construction and risk management, traditionally the asset managers’ domain.

Meanwhile, retail clients may either be woefully misinformed about the costs of the products they invest in—according to the FCA, about half of retail investors don’t know they are paying a fee at all—or may be restricted from accessing the lowest-priced funds, either because their financial advisers don’t suggest them, or because their fund supermarkets don’t have them on the menu.

If it may be uncomfortable reading for many active asset managers, the FCA’s report threatens even worse news for the consultants and supermarkets, whose business models are now under close regulatory scrutiny.

But while the FCA report provides substantial evidence that there is cartel-like behaviour amongst active managers, it’s striking how competitive the passive funds business has become (see the sharply falling ongoing charges figure in the second chart above).

We’ve witnessed a wave of competition amongst ETF providers in the last few years, with firms forced to cut fees to compete with the likes of Vanguard, which prices its funds at cost.

There’s also been a substantial automation of passive fund management, with firms seeking to cut out expensive human intermediation and improve their operational efficiency.

The FCA’s survey reminds us of some basic human psychology. Every basis point in fees matters if you’re trying to track an index, while if you’re sold on high future performance you may turn a blind eye to what you pay. This is despite the overwhelming evidence that the costs you incur are the best indicator of what you’ll end up with.

So there will always be some demand for high-octane versions of fund management, with the associated high fees. But for the bulk of the active funds industry, there’s now a version of passive management that threatens to eat their lunch and shave zeros off the annual bonus.

The evidence released today by the FCA suggests that smart beta funds, which aim to deliver better risk-adjusted returns than conventional index trackers by using alternative weightings, are likely to take substantially more market share.

(Disclosure – I’ve done paid writing work in the last year for firms that provide smart beta and index products) 

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For the 1929 Wall Street crash to turn into a global depression, one extra ingredient was needed: protectionism.

The Smoot-Hawley tariff, applied in June 1930 by the US government to agricultural imports, set in train a cycle of tit-for-tat measures that brought global trade down by a half in two years.

The succession of events that followed is well-known: rising poverty and unemployment, growing left and right-wing extremism throughout Europe, international tensions and, eventually, war.

The pro-Brexit result of last week’s UK referendum is the closest 21st century equivalent to Smoot-Hawley we have yet seen. The symbolic importance of the imminent withdrawal of the world’s fifth-largest economy from its largest tariff-free trading zone is hard to exaggerate.

This shock event has taken place against a rapidly deteriorating outlook for world trade and may well signal the acceleration of the trend. According to a sobering recent research note from Insight Investment, protectionist and discriminatory measures are becoming more commonplace.

The US has introduced 43 trade barriers to protect its steel industry in the past seven years, says Insight, recently culminating in a new tariff on Chinese steel. Over the same time period Europe has introduced 14 new anti-dumping duties.

Last week, the World Trade Organisation (WTO) reported that, between October 2015 and May 2016, members of the G20 group of leading industrialised nations implemented new protectionist measures at the fastest rate since the WTO began keeping records in 2009.

During this period, the WTO said, the G20 economies applied 145 new trade-restrictive measures, equating to an average of almost 21 new measures per month.

Insight’s CEO, Abdallah Nauphal, cites alarming demographic trends and the growth in debt levels as other factors threatening to rend politics more insular and international cooperation much more difficult over coming years.

Global trade volumes, which for decades have risen at a faster rate than GDP, have lagged economic growth rates ever since the financial crisis and are now in decline: the value of global trade fell 14 percent in dollar terms last year. The Baltic Dry index, a barometer of the global shipping market, is bumping along at multi-year lows.

According to a new article by Jeffrey Rothfeder in the New Yorker, the average charter rate for the largest cargo carriers has fallen from two hundred and fifty thousand dollars in 2008 to less than three thousand US dollars per day now, reflecting massive overcapacity in shipping and falling demand. That’s a stunning, 99 percent decline in eight years.

Signalling rising protectionist sentiment, one of the ideological leaders of the Brexit campaign, Chris Grayling, threatened this weekend to restrict agricultural imports from France to the UK if Paris or Frankfurt tries to “emasculate” the UK’s financial sector.

The right-wing members of the Brexit campaign have long agitated for immigration controls, step two in an attack on the EU’s basic principles of free movement for goods, labour and capital.

Boris Johnson, the putative leader of the next Conservative government, sought to play down such fears this weekend, but only by making the absurd claim that UK citizens would be able to enjoy access to the rest of the EU, whether to work or live, while the UK would be able to control movement in the other direction via an immigration points system.

If restrictions on the free movement of goods and people spread across the region and worldwide, limits on capital flows will surely follow. Taken together, these trends threaten an economic recession on a scale not seen since the 1930s.

Brexit is likely to go down in economic and political history as signalling the start of a very dark period.

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US mutual fund manager Third Avenue Funds’ justified its decision on Wednesday to gate redemptions from its Focused Credit Fund (FCF) as follows:

“We believe that, with time, FCF would have been able to realize investment returns in the normal course. Investor requests for redemption, however, in addition to the general reduction of liquidity in the fixed income markets, have made it impracticable for FCF going forward to create sufficient cash to pay anticipated redemptions without resorting to sales at prices that would unfairly disadvantage the remaining shareholders.”

Instead, investors remaining in the fund will be placed in a Liquidating Trust and will have to wait for the return of their money until the fund manager can dispose of the assets at what it calls “reasonable prices”. That may take months or more.

US mutual fund investors entering and exiting a fund do so on the basis of the fund’s net asset value (NAV), which is hard to determine in illiquid markets. If exiting investors are able to do so at prices that do not reflect the liquidity of the underlying market, they obtain an unfair advantage over those remaining in the fund, whose interests are diluted.

A central question is unanswered in Third Avenue Funds’ statement. Why not mark down the fund’s NAV until it reflects the price at which its portfolio of junk bonds can be sold?

Marking fund NAVs to the “bid” side of quotes in the portfolio is common practice in a bond fund, since it represents the most conservative approach. A portfolio of assets is realistically worth what it can be sold at.

The fact that Third Avenue felt unable to do this is the most worrying aspect of its fund closure. There are persistent reports that liquidity in junk bonds is so poor that a request to market makers for a quote on a portfolio can be left unanswered. Bonds go “no-bid”, in other words. As a former market maker in emerging market debt, I remember from the Russian crisis of 1998 that the market could simply stop and there was no prospect of selling your holdings at all.

The risk of bond illiquidity reoccurring on its scale has been masked by central banks’ zero interest rate policies. As many have argued, putting illiquid, higher-yielding assets in funds promising daily liquidity to investors has created large-scale structural risk. In simple terms, it’s been an accident waiting to happen. Following Third Avenue Funds’ decision to suspend redemptions, the managers of other funds investing in junk bonds, bank loans and emerging market debt will be looking nervously over their shoulders.

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When you agree a trade with a counterparty you’re done, filled, executed, correct? My word is my bond, and all that?

Depending on where you do your trading business, yes, possibly, or not at all. In the worst case, you may have granted your counterparty a free option to reprice trades to its advantage.

Following last week’s dramatic breakdown of the Swiss franc/euro currency peg, several electronic FX brokers decided to “revisit” executed client orders.

For example, according to commenters on the Bronte Capital blog and elsewhere on the internet, Saxo bank told its clients that trades agreed and confirmed in the immediate aftermath of the currency move would be moved to a level more favourable to the broker.

One client’s apparently executed stop-loss at EurChf 1.20 was moved to 0.9625, another’s from 1.184 to 0.9625. For leveraged clients, such a repricing may have turned a painful shock into insolvency.

How are Saxo-like repricings possible?

It turns out that the Danish bank had covered itself via the legal small print of its client contracts, which stated:

“It is possible that errors may occur in the prices of transactions quoted by Saxo Bank. In such circumstances, without prejudice to any rights it may have under Danish law, Saxo Bank shall not be bound by any Contract which purports to have been made (whether or not confirmed by Saxo Bank) at a price which: 

(i) Saxo Bank is able to substantiate to the Client was manifestly incorrect at the time of the transaction; or 

(ii) was, or ought to have reasonably been known by the Client to be incorrect at the time of the transaction. 

In which case Saxo Bank reserves the right to either 1) cancel the trade all together or 2) correct the erroneous price at which the trade was done to either the price at which Saxo Bank hedged the trade or alternatively to the historic correct market price.”

But surely exchange-based trades—where the exchange stands between buyer and seller—aren’t vulnerable to such after-the-fact repricings or cancellations?

Unfortunately they are.

In 2013 Goldman Sachs was able to bust (get out of) a large number of options trades which it had priced incorrectly, apparently as the result of a computer error.

But why was Goldman able to do so, when in a similar case a year earlier market maker Knight incurred huge losses and was forced into a fire sale of its business?

Because the rules of NYSE Euronext’s options trading venue, where most of Goldman’s losing options deals were apparently executed, permitted it.

By contrast, cancellation trades for equities (imposed after the 2010 “Flash Crash”, another case of trades being torn up after the event on the basis of an arbitrary judgement by the exchanges involved), were apparently stricter, meaning that most of the trades spewed out by Knight’s rogue algorithm were forced to stand.

But it gets even more complicated. According to Bloomberg, while NYSE Euronext voided its share of Goldman’s options trades, the bank’s options trades executed on other exchanges were either left untouched or repriced:

“The majority of the reviewed trades at the International Securities Exchange were adjusted and not canceled, based on the exchange’s rules, Bats Global Markets Inc. let the few hundred trades on that venue stand while Boston Options Exchanges adjusted trades.”

“It’s crazy when you look at how ISE does it one way, CBOE does it another way, Amex does it yet another way, that is absurd and it is demonstrably dangerous,” Mark Longo, founder of the Options Insider, told Bloomberg at the time.

“Let’s say you’re a market maker and you put up the same trade on three different exchanges, then you have three different processes you have to deal with to bust or adjust the exact same trade and you may have three different outcomes. How is that beneficial to anybody?”

Good question. And in the aftermath of another algorithm-accelerated rout in the Swiss Franc last week, it’s one that every investor should be asking. Understand how the rules of your trading venues or counterparties work in a market crisis or you risk being the next victim.

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Take two exchange-traded funds (ETFs), both on sale to retail investors, both investing in dollar-denominated high yield bonds. The funds are run by the same asset management firm, both track an index from the same benchmark provider and both promise their authorised participants (APs) the ability to create and redeem fund units daily on the basis of the underlying net asset value (NAV).

APs are the entities that transact in wholesale lots with an ETF fund issuer, an interaction that dictates how the fund is priced in the secondary market, where most of us buy and sell it.

Yet in one prospectus we read that the ability of investors to exit the fund may be curtailed in a number of circumstances. The ability of APs to redeem their fund units, says the prospectus, may be suspended if any of the principal underlying markets are closed or if the fund’s directors decide it’s difficult to determine the NAV.

More broadly, redemptions can be halted if the directors decide a suspension of dealing is in the interests of the fund, its shareholders or the investment company (an “umbrella” structure under which tens of ETFs are issued).

And even if none of these things occur, the fund may limit redemptions to 10% of the fund’s assets a day, meaning that large withdrawals may be scaled down and that those heading for the exits may have to wait.

Under any of these circumstances you could expect secondary market trading in the ETF to come to an effective halt.

In the other prospectus—remember, for a fund sold by the same firm, tracking an index in exactly the same asset class—there’s no mention of a possible suspension of redemptions.

All we read is that “if particular investments are difficult to purchase or sell, this can reduce the fund’s returns because the fund may be unable to transact at advantageous times or prices” and that, if it’s difficult to obtain reliable quotations for securities held by the fund, its manager may use a so-called “fair value” approximation of the securities’ worth in order to calculate the NAV.

Why the difference in language? The first fund operates in Europe and in compliance with the region’s UCITS rules. The second is a US ETF, operating according to the 1940 Investment Company Act, the governing regulation for US mutual funds.

A central principle of the 1940 Act is that investors should be able to redeem their fund units on demand. Unlike in Europe, where local regulators accept the possibility that redemptions may be suspended or “gated”, the US mutual fund rules dictate that fund inflows and outflows should continue even when the liquidity of underlying markets is compromised. There are very narrow exceptions to this principle, mainly relating to the closure of local (US) equity markets.

Does this difference in regional approaches matter?

In its March 2013 principles for the management of liquidity risk in collective investment schemes, IOSCO, the international coordinating body for securities regulators, accepted that liquidity crises in funds are less likely to cause systemic confidence problems than when the same occurs in the banking sector. Investors know they can lose money when buying a fund, or they should do.

But IOSCO’s principles are very high-level and non-prescriptive, no doubt as a result of the transatlantic differences in fund frameworks. In 2012 the regulatory body skirted around the fundamental gap in mutual fund rules by saying that the suspension of redemptions by a mutual fund may be justified only if permitted by (local) law.

IOSCO—whose principles are non-binding—has advised fund managers that they should not promise more frequent liquidity to investors than is appropriate for the underlying asset class and that liquidity risk and a fund’s liquidity risk management process should be effectively disclosed to prospective investors.

Again, this is subject to very wide interpretation in practice. Mutual funds promising daily redemptions (and, in the case of ETFs, instantaneous dealing), now invest on a large scale in a variety of asset classes that have been prone to liquidity crises in the past, from high yield bonds, to emerging markets equity and debt and even senior bank loans.

BlackRock, the asset manager responsible for the two ETFs I mentioned earlier (Europe-listed SHYU and US-listed HYG), has recently called for globally consistent best practices for fund structures, liquidity risk management and investor disclosure.

This is a hot topic, with those charged with ensuring the stability of the financial system now taking a much closer look at whether mutual fund run risk could cause wider contagion. IOSCO and the G-20 Financial Stability Board are due to issue a new consultation on systemically important non-bank financial institutions by the end of the month.

If a fund issuer gates redemptions in one jurisdiction, could there be a run from its funds elsewhere? I don’t know. But while local rules continue to differ so markedly, it’s hard to see how US investors are getting the same message on fund liquidity risk as those in Europe.

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US fund manager PIMCO is apparently being investigated by the US regulator for valuing bonds in its Total Return ETF differently to the prices at which it bought them, providing a temporary boost to fund returns as a result.

“The inquiry comes amid escalating scrutiny by the SEC of whether investment funds are valuing assets accurately and fairly,” reports the Wall Street Journal.

In one sense this is hardly a story at all. In another it’s a very big issue. Why?

The reasons why PIMCO’s reported behaviour may not have breached standard market practice are the following.

First, unlike in the equity market, the liquidity of the bond you’re trading depends greatly on the size of the deal.

“On a typical [corporate] bond issue, the bid-offer spread on a US$1 million transaction might be 1 percent  of par value, but for a smaller order the spread might be 3 percent  or more,” a bond trader told me a couple of years ago.

Press reports suggest that PIMCO may have been buying odd lots of bonds (with wide bid-offer spreads) for its ETF and valuing them assuming more standard deal sizes, generating an apparent (though temporary) performance boost to the ETF. This assumes that the fund manager was able to buy its bonds on the “wrong” side of the spread: at or close to the bid price. Unusual, but possible, given PIMCO’s clout.

Second, mutual fund managers’ practices in valuing bonds vary widely and typically allow the managers a great deal of discretion. Yes, managers use external pricing services, but they often retain significant control over pricing policies.

PIMCO’s Total Return ETF prospectus tells us that “portfolio securities…are valued at market value. Market value is generally determined on the basis of last reported sales prices, or if no sales are reported, based on quotes obtained from a quotation reporting system, established market makers, or pricing services,” and that “securities…for which market quotes are not readily available are valued at fair value as determined in good faith by the Board of Trustees. The Board of Trustees has adopted methods for valuing securities and other assets in circumstances where market quotes are not readily available, and has delegated to PIMCO the responsibility for applying the valuation methods.”

So if your bond is relatively illiquid and has a 3% spread between bid and offer prices you have pretty free rein to value it anywhere within that spread, as long as your approach is consistent. This practice may strike outside observers as lax, but it’s how the mutual fund business has long worked.

In 2007, academics from the Mason School of Business published a prize-winning paper showing how the same corporate bonds are priced differently by different mutual fund groups. Some fund firms priced a bond based on secondary market bid prices, others based on the mid-point between bid and offer prices. Around a third of the firms (like PIMCO) refused to tie their pricing policies explicitly to bid or mid prices and instead referred to pricing on the basis of “fair value”, a concept affording substantial discretion to the fund managers.

The academics also produced evidence of return “smoothing”: those funds that had outperformed had a tendency to mark bonds at higher prices, while those that had underperformed tended to do the reverse.

Such smoothing basically cheats one or more of three constituent groups: existing, new, or redeeming fund investors, since someone is dealing at too favourable or too unfavourable a price. But according to the plentiful evidence supplied in the paper, this practice has been going on for years, and it’s not against the rules.

Unless the SEC’s enforcement policies have changed markedly (and I can’t find any evidence for this), I can’t see how it can nab PIMCO for its valuation practices, however loose the “fair value” pricing policy might sound, that have been industry practice for years, as long as the firm was acting consistently and in accordance with the prospectus language.

Cases where the regulator has brought enforcement action against a fund group have tended to involve much more dramatic overstatements of funds’ NAV than those reportedly involved in the PIMCO case.

On a deeper level, this story is of course quite alarming. It reminds us of how deeply illiquid large segments of the bond market really are, even with the recent near-zero levels of interest rates, and how we disguise that illiquidity by putting bonds into daily dealing mutual funds and ETFs and marketing them as more liquid than their constituents. This comment isn’t aimed at PIMCO, by the way.

There’s an irony here, as well. The SEC that’s reportedly investigating PIMCO for overoptimistic valuation policies in a bond fund was long set against reforms forcing money market funds–another type of mutual structure–to value their holdings at market prices, rather than at a notional (and often fictitious) $1 a share. But that’s another story.

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On the face of it, mutual funds are a huge global success story.

Assets in collective investment schemes have grown seven-fold in two decades and now top $30 trillion.

Growth in global mutual fund assets

mutual fund assets

Source: Investment Company Institute

Yet the mutual fund structure contains weaknesses.

First, funds need to apportion correctly the costs associated with investors entering and departing the fund, a tricky job. So-called dilution levies (also called entry fees or front-end loads) and exit fees are there to make sure that the costs of any purchases (or sales) of securities incurred on behalf of an entering (exiting) investor are borne by that investor, rather than by the rest of the fund holders.

Unfortunately, many fund managers have historically set entry/exit fees too high and used them as a disguised source of revenue.

A more important drawback of funds is that they may carry liquidity risk.

If a fund invests in less liquid assets but promises immediate liquidity to its investors, the fund manager may cope with a sudden withdrawal of investors’ funds by selling the most liquid of the underlying assets. This would disadvantage those remaining in the fund by leaving them with a rump of less liquid securities. As a result, investors are incentivised to “run” from a fund in stressed market conditions.

Given the increasingly large size of many mutual funds (including ETFs) and the potential liquidity problems in certain asset classes (like corporate debt) it’s not surprising that regulators have been focusing on fund liquidity as a potential source of broader, systemic risk.

In most jurisdictions, the managers of mutual funds have the little-advertised ability to “gate” (ration) redemptions—a right that, if invoked, could contribute to a panic.

Mutual funds have historically been expensive, too. ETFs are a welcome recent exception to the trend of overcharging, but fund fees pay for hefty salaries at asset management firms, as well as for the services of a whole range of middlemen: lawyers, accountants, custodians and transfer agents.

The world’s largest investors don’t use mutual funds: they insist on their own, flexible managed accounts. What if smaller investors could follow suit?

It turns out that they now can.

Firms like US-based Motif Investing allow you to buy a diversified, thematic portfolio of stocks in one transaction. Motif charges $9.95 for a trade in up to 30 stocks, much cheaper than online brokers’ rates for buying or selling 30 individual securities. You can customise your own portfolio (called a motif) or copy someone else’s.

You end up with an investment that’s very similar to an index fund, but with significant advantages: no annual fees, no administrative overheads, no worries about how costs are mutualised and no concerns over gating. Unlike some funds, a stock basket doesn’t lend shares, use derivatives or incur collateral risks.

Under this model you own the stocks in your motif, with full entitlement to dividends. You retain voting rights, rather than delegating them to an anonymous fund manager, who may not even use them (except, potentially, if the small size of your basket means you own fractional, rather than whole units of shares).

Mutual funds first came into being as a way of spreading risk. Reducing company-specific exposure via a shared portfolio seemed an attractive prospect for European investors recently scarred by Tulipmania and the South Sea Bubble.

But that technological advance came nearly three centuries ago. Now we can see the prospects for another significant shift in the savings market. The emergence of cheap, tradeable thematic baskets of stocks threatens to render funds obsolete.

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Active fund managers may offer poor value for money. But some index fund costs are hidden too.

Professor David Blake of Cass Business School has just released a paper in which he argues for better disclosure of the costs of active management.

Between 50-85% of the costs of active management fall outside the headline “ongoing charges” figure that every European retail fund has to display, estimates Blake.

Commissions and taxes paid on securities trades undertaken by the fund manager are excluded from ongoing charges, for a start.

Other, harder-to-measure “invisible” costs, as Blake calls them, include the bid-offer spreads payable on trades in securities, transaction costs in any underlying funds, hidden revenue earned by the fund manager from stock lending or interest, market impact costs and market timing costs.

The high undisclosed costs of active fund management are often used by advocates of passive funds as an extra justification for indexing.

Unfortunately, some of the arguments being made in favour of indexing are fallacious.

In another study published this month, Blake and co-authors Tristan Caulfield, Christos Ioannidis and Ian Tonk argue that active management is not worth paying for.

Having measured the performance of 561 domestic UK equity funds against the FTSE All-Share index over 10 years, Blake, Caulfield, Ioannidis and Tonk conclude that “the average mutual fund manager cannot ‘beat the market’ (i.e., cannot beat a buy-and-hold strategy invested in the market index), once all costs and fees have been taken into account.”

There’s a major problem with this argument. Tracker funds don’t match the market index, as Blake appears to assume as a matter of fact: they underperform as well.

Clearly, you should expect any index-tracking fund or ETF to lag its index by the annual ongoing charges, which are admittedly smaller on average than those of active funds.

But in harder-to-track equity markets the underperformance of the average index fund/ETF may be greater than the headline fee would imply. This occurs as the result of extra, frictional costs that closely resemble the hidden charges Blake talks about in the context of active management.

For an example of this effect, note that most trackers of the MSCI Emerging Markets index underperform it by more than their ongoing charges (see this recent Lyxor publication for evidence).

This additional performance lag occurs as a result of access costs: you pay more in the form of bid-offer spreads, taxes and commissions when buying stocks in smaller and less developed equity markets. Index funds have lower turnover, on average, than active funds, but they do trade.

[Disclosure—I’ve recently done writing work for Lyxor]

Index fund managers can, however, mask their funds’ underperformance in ways that are even less transparent than some of the below-the-surface active fund costs described by Blake.

One way to do this is to include extra costs in the index (whether as an index fee or, more cleverly, by depressing the assumed post-tax dividend rate in a total return index to make the fund’s performance look better).

If the index fund manager also gets to produce the index, a practice that the US regulator now appears to be condoning, then there’s even more scope and incentive to embed additional costs, to the investor’s detriment.

Another way of hiding index fund costs is to include collateral in a derivatives-based fund that is of lower quality (from the perspective of the repo market) than the quality of the securities basket represented by the index. This generates extra income for the counterparties to the repo trade, who can pocket the revenue with the average investor none the wiser that he’s losing out at all.

The equivalent practice in a physically replicated tracker fund is to exchange the index securities via a securities loan for lower-quality collateral, again resulting in extra income, a large portion of which has historically been retained by the fund issuer or its affiliate.

There’s a little more transparency regarding these practices than there used to be, and more of this hidden income is now being credited to fund investors than before. But securities lending and repo market trades are also much more characteristic of index-tracking than active funds, meriting extra scrutiny when indexing is involved.

It’s worth reiterating that if you buy an index fund assuming that you’ll get the index’s return, you are making a mistake. And if you compare index funds on the basis of their headline fees only, you are ignoring potentially substantial hidden costs.

I’m a fan of ETFs and am all for criticising active fund managers if they are providing poor value for money. But we shouldn’t give indexing a free ride as a result.

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Manipulating interest rate, currency and commodity benchmarks will soon be a criminal offence in the UK, carrying the threat of a seven-year jail sentence, according to press reports.

Meanwhile, evidence mounts of an epidemic of benchmark-rigging.

The 2012 LIBOR scandal has been followed by other alleged cases of price-fixing, involving gold and foreign exchange.

Traders have gone on the record to describe traders’ attempts to skew survey-based energy benchmarks by submitting unrealistic prices that suited their trading positions—just as occurred with LIBOR.

Other types of market manipulation appear to have taken place in the financial instruments used by indices underlying tracker products.

In 2009 I published an article describing how investors in oil ETFs were being hit by apparent front-running in the futures contracts being used by the trackers as reference prices.

Unsurprisingly, the business of producing indices and benchmarks is now under intensive regulatory scrutiny.

Those compiling benchmarks have to comply with IOSCO’s 2013 principles for financial benchmarks, which set new governance and transparency requirements, by next month. The European Commission has its own draft benchmark regulation on the table.

Some of the firms involved in benchmark-setting are deciding it’s not worth the hassle—or the increasing potential legal liability—to continue. Deutsche Bank recently resigned from the daily London gold and silver fixes, having failed to find a buyer for its seat on the fixing panel.

Requiring greater transparency in benchmark-setting, introducing new sanctions and bringing about a greater separation between those calculating benchmarks and those involved in trading should help to counter the worst abuses.

But none of these things will make benchmarks immune from attempted manipulation.

Even share indices, which, unlike oil, FX and interest rate benchmarks, are calculated using prices from relatively transparent public markets, are not fool-proof.

All indices undergo periodic rebalancing. When index providers announce details of the stocks due to enter and exit their benchmarks some traders seek to profit from the information during the period between the announcement and the date of the index change itself.

Index firms can change the benchmark rules to try and counter attempted front-running, for example by randomising the dates on which the rebalancing occurs within that time-frame. This may deter manipulators, but it also detracts from the index’s transparency. A benchmark using opaque construction rules wouldn’t work as a benchmark at all.

There’s no perfect solution here. The most popular benchmarks are used in financial products because they have gained widespread acceptance and met a market need. $350 trillion of derivative products were reportedly linked to LIBOR, which was originally seen as a superior, market-based alternative to official central bank interest rates. But such volumes of traffic attract those seeking to influence prices or flows.

The more accepted an index or benchmark becomes, the greater the inefficiencies it may generate.

Heavier fines and jail sentences may deter the worst cases of benchmark-fixing. But some attempts at market manipulation are an inevitable result of the use of indices and benchmarks as reference prices in financial products.

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Regulators are angry about those abusing benchmarks.

This week the head of the International Organisation for Securities Commissions (IOSCO), David Wright, said that benchmark riggers should face tougher sanctions.

Wright’s comments come in the wake of a fine handed down by the UK securities regulator, the Financial Conduct Authority (FCA), to Barclays for lax controls in allowing a trader to influence the daily gold fix in 2012.

The trader’s motivation was to prevent his bank having to make a payout under a derivative contract called a digital option. The trader succeeded in influencing the fix to his benefit, but the client who had bought the derivative suspected manipulation and complained. Barclays, together with the FCA, unveiled the fraud.

This abuse is directly reminiscent of the LIBOR manipulations revealed in the same year, 2012. According to one hedge fund manager quoted in yesterday’s Financial Timesthe influencing by banks of  prices in the markets underlying such digital options is “routine” and the Barclays case is “the tip of the iceberg”.

The average investor can draw one obvious conclusion from the latest episode of benchmark manipulation: don’t buy a financial product from an institution with the motivation and the capacity to influence the reference price underlying the product.

The Chinese walls supposedly in place to separate the benchmark calculators and the traders within a single organisation may have ears.

That applies just as much to the market for index-tracking ETFs and ETNs, where some product issuers also design and calculate the underlying index. In the wake of the LIBOR and gold fixing scandals, such a lack of separation of duties is a warning.

The problem in regulating all of this is that some of those closely connected to current public policymaking don’t have clean hands.

Government agencies (in the form of central banks) are arguably the biggest benchmark riggers of all: think attempts to control foreign exchange and interest rates and the current policy of quantitative easing, which has driven bond yields to well below and asset prices to well above fair value.

And central banks may have been involved in worse behaviour than that. A commenter on yesterday’s Financial Times article, Julian Wiseman, former head of interest rate strategy at bank Société Générale, makes the observation that:

“The most prolific offenders at defending digital barriers (binaries, knock-ins, knock-outs) used to be the Asian central banks. Around the turn of the millennium a significant part of the FX market was knowing who wanted what. Investment banks would sell the exotic options to Asian CBs knowing that they would lose on that position, but that loss was merely the price of the information, which could itself be used profitably.”

Will IOSCO and other regulators now prosecute the central banks, Wiseman asks, rhetorically?

Uncovering this type of market abuse will be harder than hitting the banks while their reputations are at a low ebb.

But if regulators are serious about fixing the system of market benchmarks they should broaden their investigations to include the official sector.

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