By Tim Dulaney, PhD and Tim Husson, PhD
Structured products are often linked to well known indices like the S&P 500 (PDF) or the Dow Jones Industrial Average (PDF), but recently it has become more and more common for banks to issue structured investments linked to proprietary indices that they create themselves. The use of proprietary indices (also known as 'self-indexing') has begun to arouse suspicion from various sources and so we thought we'd take a step back and talk about the issue for a moment.
Structured products linked to well-known indices or stocks are considered easier to market since the indices are widely quoted (on the evening news for example) and fully described by the index provider (S&P, Russell, MSCI, etc.). Investors benefit from the independent and transparent nature of these widely distributed indices.
The downside for issuers of using an S&P, or a Russell or an MSCI index is that there are licensing fees. Although the marginal fees for more frequent issuers tend to be small, these licensing fees can amount to a few basis points (100 basis points = 1%) and can eat into the profits of less-frequent issuers. In light of these fees, banks are more frequently testing the waters with in-house indices.
Using proprietary indices benefits banks by decreasing fees paid to index providers, but at the cost of transparency to the investor. Take as an example JP Morgan Chase Bank. This bank has been issuing a number of structured certificates of deposits linked to proprietary indices like the JPMorgan ETF Efficiente 5 Index (here's an example CD). If you've never heard of this index, you're not alone.
According to the SEC filings for the index, it allocates between exchange traded funds based upon a momentum strategy with a volatility target of 5%. "Investors can access the index via J.P. Morgan-issued certificates of deposits and notes, each of which is subject to the credit risk of the particular issuer." In other words, there isn't much else out there that references this index.
When complex in-house indices are used over transparent and independent indices, there is a possibility for investor abuse. Rosa Abrantes-Metz, an NYU expert on benchmarks, states that "any institution that has a direct financial interest in the value that a benchmark takes should not be responsible for administering such a benchmark, especially if they are not based on actual transactions." The risk is that the issuer may use its informational or discretionary advantage to increase the profitability of its products at the expense of investors. Indeed, it is very difficult for investors to value structured products linked to proprietary indices, as the relevant market information is often not available.
It should be noted that some of the most vocal opponents of proprietary indices are, not surprisingly, the index providers themselves. The use of proprietary indices reduces their revenues and diminishes the prominence of their benchmarks. In this particular case though, it seems that the interests of the investor and of the independent index provider might be aligned.
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