Ex-Barclays Quant Wants to Clean Up the $11 Trillion Index Boom

(Bloomberg) -- After spending most of his career helping indexes take over the investment world, these days Laurence Black deals with the fallout from the $11 trillion monster he helped unleash.

As a creator of complex quantitative gauges at Barclays Plc, he contributed to a benchmark boom that critics say has spun wildly out of control, with around 3 million in existence globally compared with about 45,000 listed stocks.

Now pandemic-lashed markets are exposing all manner of dangers, from poorly understood and risky structures to hyper-concentrated portfolios. Black, an adviser to Nobel Laureate Robert Shiller, founded consultancy The Index Standard to tap surging investor demand to make sense of the madness.

“Apart from all the complexity, the barriers to entry and technology have enabled almost anybody to launch an index,” said Black, Barclays’ former head of quantitative indices and strategies. “The seal of quality is not there.”

The idea is that those 45,000 stocks have an army on Wall Street and beyond analyzing their every detail. In comparison, hardly anyone evaluates indexes.

Yet the risks of the boom are increasingly being laid bare.

Take the explosive growth of thematic exchange-traded funds, epitomized by Cathie Wood and Ark Investment Management. While Wood mostly runs active strategies, there’s now a slew of ETFs using indexes to deliver similar exposure to trends like robotics and autonomous driving.

Black says that there simply aren’t enough companies in these sectors to fill such benchmarks, so index providers end up pulling in firms from other industries. Or they funnel all the money to a handful of shares.

“Sometimes, these indices can end up taking quite large exposures to relatively small stocks,” said Jay Watson, who joined Black’s venture from Barclays this year. “You can worry about the tail wagging the dog.”

The Index Standard rates and reports on gauges across asset classes, looking to sort good from bad and help clients sidestep potential dangers. The firm sells its work to the likes of insurance carriers, marketing agencies and research groups, with the aim of expanding to everyone from banks to financial advisers.

$11 Trillion

With more than $11 trillion now in index funds, understanding the benchmark boom is of growing importance to Wall Street.

In the course of five decades, the industry has slashed costs and simplified investing for millions, and is continuing to grab market share from discretionary managers. Yet within markets are vast differences in both performance and risk -- even in the same types of index.

Among U.S. ETFs targeting value shares last year, for example, there was a 30 percentage point difference in performance between the best and the worst returning funds. Fees, strategy and structure can all vary wildly.

To make its assessments, The Index Standard looks at how long a gauge has been live and whether the rules are available. The firm considers historical drawdowns and how long it’s taken for the gauge to recover, and whether there are a lot of fat tails in its performance -- all with the goal of rating benchmarks within their peer group.

Black built a computer program that looks at 35 factors, with a main focus on index design and an emphasis on complexity and diversification.

“If we see too many parameters, that’s a bad thing,” he said.

Famous Friends

The focus on simplicity is ironic, given Black’s background.

The 48-year-old had a thriving career collaborating with figures like Shiller and famed investor Joel Greenblatt on complicated, high-octane benchmarks at Barclays.

Black says misunderstanding and confusion about benchmarks has been intensifying for years as they grow more ubiquitous. Now a typical annuity product sold in the U.S. can track an index following 15 ETFs, feature AI or machine learning, and target a specific level of volatility at the same time, he said.

“That index is being sold to your average adviser in the Midwest,” Black said.

It’s perhaps no surprise then that the fledgling New York-based firm has found the most traction in the U.S. insurance industry, where fiendishly complex indexes have become the norm in the multi-billion dollar market for fixed index annuities.

Black sees plenty of opportunity coming from the ETF world, where the indexes underpinning funds are getting ever wilder and weirder. Buffered ETFs for instance, which have attracted billions of dollars, use strategies borrowed from structured products to help investors protect against crashes and generate yield.

“Market conditions are driving innovation,” said Black. “But we’ll probably reach some point where it gets too complex.”

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