Index providers interview

In the first of a series of interviews with the index providers on which much of the structured products business is based, Richard Jory and Matt Cameron talk to Standard & Poor's Eudald Canadell, managing director for Index Services Europe, and Christopher O'Brien, vice-president of marketing and sales for Europe and Asia, about creating indexes and forging a global community

Q: What types of index tend to be the most popular in the creation of structured products?

A: It really depends on where we are in the market and what the market cycles represent. We have focused on the emerging markets, geographical exposure slices, the regrouping of geographies and what the market would call 'very sexy, marketable' structured products, such as the Bric countries. Because of the turmoil we have seen in the markets over the past four months, product issuers are looking increasingly at new types of diversification, and one of those is much more narrowly focused company-types or thematics. Examples are clean energy, forestry and timber, and other highly specific market slices where the behaviour or trading patterns of those companies is very similar but they still retain some geographical diversification which is not correlated to traditional equity markets, whether developed or emerging.

Q: Is there a global index for these narrowly focused types of companies?

A: There are very small subsets. For instance, if we take the S&P Listed Private Equity Index, we only identify 25 companies around the world that make the cut. If we take something like Investable Global Property, which is a very small subset of the global benchmark, it is 40 securities. When we enter an area such as infrastructure, on the other hand, because of the breadth of that sector, it is 75 securities. So the S&P infrastructure index is looked at from a global angle, although it can have a regional connotation depending on who the issuers are and their ultimate distribution channels. But for many of the other focus areas, such as water or clean energy, the regional component simply becomes a single or multiple stock option as opposed to a structured product.

Q: What kind of demand are you seeing for regional and thematic indexes, etc?

A: In the structured products realm, the interest has been more to follow global property than to bite into it, looking more at regional subsets. Market sentiment for North American and European property is very different to that for Asia. We do see interest on a regional basis in property - specifically in Asia.

We publish a quarterly global property Reit (Real Estate Investment Trusts) report, which looks at the characteristics of each region and how they compare, as well as how property compares with Reits. It is probably the publication that has had the most uptake - not only on the institutional side but also by investment banks.

Standard & Poor's listed property indexes include commercial and residential property. The indexes are broken down into nine peer groups, comparing healthcare facilities to retail rental, and to commercial malls, and so on. That is more useful analytically for those modelling products than basing individual issuances on just commercial property or healthcare facilities.

Q: Environmental and ethical themes are often grouped together. How do you deal with that? And to what extent are you finding an increased popularity for these indexes?

A: Standard & Poor's does not calculate socially responsible investable (SRI) indexes, although we create them on a custom basis for outside parties. We calculate sharia indexes, which can be compared in certain ways to SRI indexes. We also calculate various themed indexes, such as those themed on water. We construct those by first identifying which companies are related to the economic drivers of the particular sectors. Rather than say that we will go and score companies, or invent our assessment of these companies before disclosing that and subjecting it to individual perceptions and considerations, we use S&P's internal technology and tools - notably the Capital IQ Platform. Capital IQ holds information on listed and unlisted corporations and is one of the premier tools by which private equity investors can identify companies, transactions and what goes on in different local markets.

We use the tool to identify listed companies that are active in water, for example. This would include those that have declared revenue coming from water activity and those that appear in the media together with any mention of water. We would do the same thing for companies related to clean energy and nuclear energy, for example. Once we have identified a pool of companies, we score them based on how embedded they are in the sector, and therefore how they are influenced by macroeconomic trends.

Then we look at the liquidity required to trade the baskets - how big can the basket be? Based on the answer, we will identify cut-offs and use modified market capitalisation-weighted schemes to construct a liquid basket. We do not seek to make specific judgement calls, or to develop individual methodologies based on what is environmentally sound. We take information on public companies and use those in the scoring process.

Q: So do you score them to create an index which is a certain amount water, a certain amount clean energy, biofuel, wind energy, and so on?

A: No, we score them to create an index which is specific to clean energy or water, for example, but not combined. There is no amalgamated index.

Q: Have you looked at creating an amalgamated index?

A: These companies could be combined into a green index if you wanted to take several of them, but I think what you are going to end up with is a subjective definition of what is environmentally sound or what is green. The response from issuers is easy to predict: some will say that you can put two or three themes together, somebody else will say that you can't. We tend to stay away from a subjective call and try to substantiate as much information as possible with objective measures.

Q: Some banks have tried to create their own indexes and have had various cut-offs where at least 50% of the business has to be directed towards the environment or its preservation, which does have a degree of subjectivity...

A: But that can develop into objectivity; if it is based on sources of revenue then it can be objective. But wherever we consider there to be a certain amount of subjectivity, we try to stay away.

Q: So you don't have an ethical index?

A: How do you define 'ethical'? We don't produce an S&P ethical index. But we do create them on a custom basis for third parties. S&P can calculate, maintain and deliver such an index based on others' criteria, subjective or otherwise. The banks provide us with a database, together with the criteria and screen they would like to develop (we can even help to create that screen if they give us the criteria), then you apply one to the other and you have the index.

We calculate the Ethibel SRI indexes (Ethibel is a Belgium-based company), which are publicly advertised as being calculated by S&P on a custom basis. Questions we can ask about ethical indexes concern the appropriate methodology, and the resources of any company to actually collect data and normalise it on a global basis. I don't know of many companies that have a global reach, most SRI or ethical indexes are related to one region, which means you will get dissimilar portfolios, methodologies and compositions when combining regions.

The closest thing that S&P has to SRI indexes are sharia indexes, because they correspond to Islamic law but are also based on data. The screens are based on sector composition, or more specifically the sectoral activities of those companies that are excluded (where the revenue comes from, basically). Then, of course, there are financial screens. You look at sharia and you see a company that has little cash leverage.

Q: Do you use the same percentages as the Dow Jones Islamic Market Index?

A: It is very similar. There is no right or wrong answer with sharia - it is a question of investor and adviser perception. The difference between Dow Jones and S&P is that we do two things. First, our board is composed of scholars from the Middle East. Middle Eastern sharia is generally accepted as being stricter than its Asian counterpart, hence S&P sharia products are passportable in more regions. So a Malaysian issuer can sell its products to the Middle East if they are based on S&P indexes.

Second, rather than screen a whole load of securities, as Dow Jones did in 1999, which provides a global portfolio that people can use as discretionary mandates, S&P asked: "Where is the money gravitating from? Where are the structured products created? And where are the portfolios created?" We rolled out our sharia indexes based on those areas where the majority of the market was trading.

To go back to an earlier question about property, we have an S&P Property Shariah Index, which it was the first to market when it was announced in July. The initial interest came from Asia, because it has a large Islamic community and it is where property markets have been most successful. We said, let's take those investable indexes and retain the inherent index characteristics in sharia format so that people can use structured products in their portfolios.

Q: Are you finding that people outside the sharia world are interested in that as an ethical investment?

A: The talk is that they are. That is what we say and hear at conferences, and to an extent it is true. For sharia, if you can define the methodology and it is based on quality data, it is normalised data. And it is data collected from markets that are sometimes harder to monitor, such as emerging markets. So when you ask what a particular company means in Saudi Arabia, South Korea, or the US, I can say that those three have the same approach to their environment, shareholders, and the management of their company, as well as of course to certain sectors of activity that might not be as profitable, such as sin stocks.

Q: Do you use one definition of sharia law?

A: We use one sharia board, Ratings Intelligence. It's a consultancy firm based in London and Kuwait that was originally set up to do sharia hedge fund-compliant products, and which has a board made up of four Middle Eastern scholars.

Q: Do you think investors are looking for more capital protection, and options related to more unusual and original indexes?

A: The market is more specialised now. An investor in a green index might end up investing in something like timber and forestry, where the real purpose is not really concerned with nature but with the physical advantages of the investment. The private banking world has known that for years, and now that has seeped into the structured products sphere.

Q: How much of your business comes from being a calculation agent for others?

A: Providing customers with indexes all falls into the same area of business, which is basically doing something in conjunction with your client, or doing something by special request, but it is a bit of each. It is not just that you give me a certain field and we apply it. Working together, we come up with a product that suits their goals.

In percentage terms, custom calculation is the fastest-growing area of our business in relation to structured products. We have done this for a number of years, and I would say that this business has more than doubled in value every year.

Q: Structurers like having you as calculator and a named third party, even if they don't necessarily use your index.

A: It also allows them to pass those regulatory hurdles when they want to go from a proprietary into a public product area. Many investment banks start off with custom indexes, strategy indexes, trading strategies, based on proprietary algorithms on which they use proprietary capital to test, then they will go to the market and syndicate. Having the ability to do that - even in a private placement scenario - changes the whole dialogue, not only with the market but also with the regulators.

Also, once they have dumped it on us, they don't have to do much more work on maintenance. Calculating an index takes a lot of time, such as monitoring the stock or the underlying and applying all the changes. But we take on that whole burden and the analysts at the bank don't need to do anything else.

We have the largest database of global equity, containing more than 11,000 stocks that are filed on a daily basis and including all the corporate actions dating back to 1989. We can draw out a 20-stock index from the world's largest and longest end-database quickly and in a straight-through processing environment.

Beyond the window dressing of the regulatory hurdles, take for example "what did I do with that Korean dividend, did it come today, did it come yesterday?" Miscalculating, missing, or misapplying a dividend stock split or whatnot, especially around a payout date or when there is a ratchet in the formula, can be a disaster. And so that is a transfer from the banks to us of the operational risk.

And there is a lot of exposure to emerging markets - for example, the frontier index and indexes tracking stocks in markets that are hard to reach, such as Ghana.

Q: Who underwrites the accuracy of that?

A: S&P does not guarantee accuracy, simply because it is not possible. We publish publicly available data because of our belief in its quality, but there is no guarantee. For instance, a corporate might decide to produce a dividend but not tell anybody. That is a rare example, but if it happened, nobody in the chain could be responsible for it.

Q: Has your approach to getting banks to pay for licences to use your indexes changed following the recent Commerzbank ruling? (Structured Products, March 2007.)

A: Publishing, maintaining and making our indexes available requires remuneration. In general, if you want our product as the basis for a product that you are building, then you need an intellectual property licence to do it. The modality of payment depends on what you want to have with us. We offer some very broad-reaching licences where you can do as much as you want on a certain index for a given period, or you can do it as you go, and, depending on how much you raise, you pay a certain amount. It all depends on the product and the modality, but everything starts from the licence as a fundamental cost.

The licence really is tailored to every institution, because a major investment bank that has structured products operations in three or four capital cities is going to be very different to a distribution bank in Spain or Italy. They do not use the same type of licence or indexes. Our relationship with a small distributor bank is probably going to be related to our most well-known indexes like the S&P 500 or the S&P ASX. It is the bigger investment banks, which are getting into more exotic products and exposures, with whom we have to enter into a dialogue to create these innovations, so the commercial relationships are totally different.

The way that S&P relates to institutions is, I think, very different to some of the other organisations that are either just more data-oriented and not very involved in structured products, or those that are much more active with a headline bellwether for a market or a region, and they have a sales team that is more tied to that.

Q: What kind of technology do you use for creating indexes?

A: S&P is based principally in the US but we also have actual calculation and analytical hubs in Beijing, Tokyo, Sydney and London. We also have some of the world's most valuable traded index derivatives, such as the S&P 500, the Vix, the S&P 100, the ASX, the TSX, that tick over every 15 seconds. It is a totally different configuration and the technology behind it necessitates a locally listed and locally managed IT network in the same time zone. The other index providers have another business configuration which has come about differently and I imagine the technology will be different. We do not all go to the same home depot.

We put most effort and investment into communications systems, much more than calculation. At the end of the day, calculation is a question of having the right software. But we really cannot afford breakdowns in communication, where a little problem affecting part of your index or one stock can become a big issue.

We operate a 24/5 order book. We pass the calculation from New York to London to Beijing, Tokyo and Sydney. All our teams are equipped to take over if anything ever happens in any of the other offices. So the analysts here would be able to continue with calculations if something happened in Beijing or New York.

With that technology, it is also about how you organise your business. We realised some time ago that what is necessary when creating new indexes is having one data repository and convergence between the data points. We have multiple index families for multiple reasons - some we acquired; some we built - but we draw on all this stock data for what we produce in the market. We cannot afford to have a security that does not have the same investable weight factor and the same pricing source in two different indexes.

The way we manage the data to maintain integrity allows us to turn around the indexes very quickly. Otherwise, you would need duplicate systems just to calculate that index. The same desk could be trading the same stock in two different ways for two different reasons, but imagine if a corporate action or a dividend was not applied to that stock the same day. Some index providers actually do it separately.