When Indices Are Cut: What Withdrawals Teach about Risk-Control Index Design
In an ideal world, the set of indices underlying a fixed index annuity (FIA) would remain unchanged throughout the product’s lifespan. Advisers would do their research, make recommendations, and continue to track the same set of indices.
In reality, however, carriers sometimes withdraw an index from further investment, citing “capacity issues.” This can cause frustration and anguish among advisers and raise questions from investors, especially when they have put substantial effort into understanding an index that has been delivering good returns.
How can advisers explain to their clients that, irritating though it may seem, carriers are in fact behaving responsibly by making such decisions?
In a broad sense, capacity refers to the assets under management (AUM) beyond which a strategy cannot achieve performance over time matching its stated return objectives or expectations. Reaching capacity is a reason a hedge fund may close a fund to new investors, so protecting the interests of existing investors. In the case of the risk-control indices used in FIAs, the considerations are similar, although not identical.
When a carrier issues an FIA, it usually engages one or more banks as hedge providers to offer the options on the indices that compose the FIA. The hedge providers trade the components of these FIA indices in the markets, replicating the indices’ performance and “delta hedging” the options they have sold to the carrier. The figure below illustrates the relationship.
The Different Entities Involved in an FIA
If this hedging activity makes up a significant fraction of the daily trading in a particular component of an FIA index — for example, a stock or an exchange-traded fund (ETF) — it may have a material effect on the component’s price. If, say, a hedger needs to buy $100 million of a stock, and the average daily volume traded is $200 million, the hedging would represent 50% of the usual daily liquidity. This hedging activity may feed back into the level of the FIA index itself, potentially to the detriment of the performance of the FIA — and the retirees who have bought it.
Both the carrier and the index sponsor should wish to avoid this situation — the carrier for the sake of its end clients, and the index sponsor for the integrity of its index.
The capacity of an index is not a hard-and-fast number, but rather a guideline amount at which the required hedging activity may have a non-negligible effect on index performance. In the case of an FIA index, capacity is estimated by the hedge provider at the time it agrees to start selling the options to the carrier.
So how might issues occur?
The simplest case is when an FIA sells very successfully. This is likely driven by strong performance of one or more of the risk-control indices used in the FIA, attracting inflows. The carrier must buy more options from the hedge provider, which in turn must hedge a greater volume. Everyone is happy, until the required hedge amount of one of the FIA indices approaches the capacity of that index.
And what about changing market conditions? The risk-control indices used in FIAs tend to be composed of other indices, ETFs, stocks, and futures. Component liquidity can change markedly over time. An underlying ETF may see reduced volumes if it underperforms and investors withdraw; or an underlying future may become thinly traded, with reduced open interest. In both cases, the drop in liquidity can reduce the capacity of the risk-control index.
ICLN: An Illustration
In the ETF world, the iShares Global Clean Energy ETF (ticker: ICLN) offers a good example of an index capacity issue. The ETF was launched in 2008, but as investors responded to the sustainability narrative and clean energy became a key initiative of the Joseph Biden administration, the US ETF’s AUM surged from around $700 million to about $5 billion, while the corresponding European version tracking the same index also grew to around $5 billion. The ETF was also a popular underlying for US structured products, creating a hidden demand for the stocks. The issue was that the underlying index only had 30 constituents, two of which were small, illiquid stocks listed in New Zealand.
When it came time to rebalance, the ETF needed to sell 40 to 50 times the daily liquidity of these two stocks. That would have driven significant price movements. After consultations, the index sponsor, S&P, took a drastic step: It redesigned the index and increased the number of stocks to a target of 100.
While this example applies to an ETF, not an FIA, it demonstrates how changing market conditions and demand can create serious capacity issues in index-linked products.
So, if index capacity is not a pre-set, hardcoded amount, how can carriers best avoid future capacity issues when selecting risk-control indices?
Index capacity depends primarily on the liquidity of the underlying instruments: usually other indices, ETFs, stocks, and futures. Careful selection is therefore essential. But index capacity also depends on the weighting mechanism that allocates to these instruments, the rebalancing mechanism that implements these weightings, and the risk-control mechanism that maintains the index’s volatility at its target level.
The demand for an index, its performance, and market conditions all change over time, challenging product builders and their hedge providers to guarantee provision of an index over the annuities’ longer time scales. Carriers need to take detailed aspects of index design into consideration when performing due diligence on proposed risk-control indices.
With appropriate scrutiny, they can maximize the chances of avoiding capacity issues in the future.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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