[This article previously appeared on our sister site, IndexUniverse.eu.]

ETFs were originally developed to track the indices that active managers found so hard to beat. Now, in a drive to cut costs in an increasingly competitive market, some ETF managers are seeking to “self-index”, creating and calculating their own benchmarks. Should investors in passive funds welcome this development or be wary?

US fund manager Guggenheim recently filed paperwork with the national regulator, the Securities and Exchange Commission (SEC), to develop and launch its own indices. BlackRock, parent company of iShares, the world’s largest issuer of ETFs, did the same in August. Other US ETF issuers that use proprietary indices include WisdomTree, Van Eck, Claymore, HealthShares and IndexIQ.

However, combining ETF management and index provision in the United States is legally problematic. Section 17 of the 1940 Investment Company Act (“40 Act”), which governs the large majority of US investment funds, places tight restrictions on investment companies’ dealings with affiliated parties.

Previous applications to self-index were only approved if the ETF managers concerned could persuade the regulator that they would not contravene section 17, said Kathleen Moriarty, partner at Katten Muchin Rosenman, who advised Wisdomtree and IndexIQ in their dealings with the SEC. In practice, this meant that ETF managers had to outsource the calculation role to a third party or, for example, physically separate themselves from any affiliated index provider.

In its August application, which is still under review at the SEC, BlackRock says it wishes to internalise all index-related functions, including “compilation, maintenance, calculation, dissemination and reconstitution activities”.

“In any such application to manage an index in-house, the SEC will need to be convinced that the index is being calculated free and clear of the ETF, and that the ETF manager doesn’t know what the index provider is doing,” said Moriarty in a telephone interview with IndexUniverse.eu.

According to one index industry veteran, who wished to remain anonymous, the SEC has been strict in its past interpretation of the 40 Act’s affiliated party clause. For example, the source said, when index provider IIC (now part of Markit), operator of the iBoxx and iTraxx indices, bought the $ InvesTop and the $ HYTop corporate bond benchmarks from Goldman Sachs in 2006, renaming them the iBoxx $ Liquid Investment Grade index and the iBoxx $ Liquid High Yield index, Barclays, which at the time owned more than 5% of IIC, was forced to give up its shares’ voting rights. This was because Barclays, via its fund management subsidiary BGI, owned iShares, which in turn ran ETFs tracking these indices (notably LQD, the iShares $ Investment Grade Corporate Bond Fund), said the source.

The SEC originally had concerns about possible index manipulation even when an ETF provider and firm providing the ETF’s index weren’t connected, said Katten Muchin Rosenman’s Moriarty, who also advised State Street on its 1993 application to launch the SPDR S&P 500 ETF Trust (NYSE Arca: SPY), now the world’s largest exchange-traded fund. In the case of SPY, said Moriarty, it proved relatively easy to convince regulators that the S&P 500, as a long-standing and widely followed benchmark, would not be subject to potentially malign influence from those managing tracker funds. “However, you can see the potential concern if an ETF manager is launching its own, new index, particularly in less liquid areas of the market,” she added.

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