Francois-Eric Perquel

From our European Bureau: Are European Indexes Investor Friendly?

Exchange-traded funds (ETFs) have really started to take off on the European continent this year. This growth has led parts of the financial community to raise doubts about the pertinence of European indices.

The debate centers on various issues related to indices: their general relevance, their transparency, and their fund friendliness.

The purpose of an index is to reflect the evolution of a market (or market segment). In Europe, traditional indices have been launched and maintained by stock exchanges. Therefore, each index covers only its own national market, and uses its own set of rules for maintenance.

The reliance on exchange-based indices can be acceptable if one desires indices that represent a single market or the main stocks of a given market. In many cases, this dependence limits the effectiveness of sector indices, because they tend to have too few components to be considered true benchmarks. The merger of stock exchanges does not completely solve the problem. Index provider STOXX intends to fill the sector void, but today its sector indices are far from being used as much as its general ones.

Bloomberg is also pushing hard to get its European sector indices accepted as benchmarks, which are used by Barclays Global Investors for several European ETFs. Most indices in Europe are capitalization-weighted, and many of them also take liquidity into account. This should theoretically improve the representation of the available market and facilitate use for derivative products or index funds. It can, however, also become detrimental when a few stocks have a dominant weight in the index.

The information technology (IT) craze of the past two years has provoked such a situation in various European countries. The countries with smaller market capitalizations, like Spain or Finland, have seen the weight of a single company in the index top 40%. In such a case, the capacity of the index to be a proper gauge of the relevant market is damaged. The German market anticipated this risk and created a weight cap of 15 % for any single component of its indices, including the DAX. Although the primary indices in Europe have also improved in terms of market representation, they remain too limited by their mono-market origin. With the wider use of indices initially for derivatives produces, and then later for index funds, another aspect is quite important for an index - its transparency. Paradoxically, the rules of governance, the choice of index components, and the availability of accurate and complete data are still less important than the exchange-backing of an index. The main rules of governance of indices employed by stock exchanges are easy to find. Calculation modes and index formulas are very well presented by most stock exchanges. Still, the precision of independent indexes like STOXX is not measured purely in terms of data accuracy.

All indices tend to use a quarterly or annual rebalancing, but are sometimes forced to do it more often, principally because of mergers. The discrepancies in rebalancings are explained by the different countries' cultural differences, which might give the impression that there is a lack of precision in the stock exchanges of the southern European countries. The varying rules used in rebalancing are at the heart of the problem. An expert committee generally chooses, among the companies with highest capitalization, companies that fulfill other conditions: mainly liquidity, but also volume and spread. The choice is not always made through a fixed predetermined rule. Even so, one could feel that, technically, the exchange-based traditional indices of Europe are still slightly behind the independent indices. However, one must recognize that Europe, being still highly fragmented in its investing patterns, relies mainly on the traditional indices. That is the reason why they are far more recognized by the individual investor. As a whole, the main indices in Europe are quite fund friendly because they adapted themselves to support derivatives in the 1980s. They are mainly cap-weighted and include the most liquid stocks. Their only weakness lies in the relative lack of transparency in the rebalancing process, and in the occasional limitations of capitalization weighting of providing adequate diversification. This last aspect brings us to a paradigm (at least for smaller markets): Index funds are meant to represent the market evolution because they track an index that is supposed to be a fair representation of the market. Index funds need indices that are fund friendly to avoid higher transaction costs and turnover inefficiencies. This includes having fully capitalization-weighted indexes to provide an accurate reflection of the investable market. The problem is that this sometimes leads to having a fund that is highly dependent on one, two, or three stocks - rather than on a diversified market.

François-Eric Perquel is the author of the book Eastern European Financial Markets, and is currently based in Barcelona, Spain. Mr. Perquel has held several important positions within the European financial community, including service as an independent consultant during the establishment of Easdaq.