On September 20, Germany’s flagship DAX® Index will expand from 30 to 40 constituents, concluding the biggest reform in the benchmark’s +30-year history.
The enlargement is the final step in a comprehensive overhaul of rules announced in November 2020 that reflected responses in an extensive market consultation. The changes seek to simplify the construction methodology of the DAX Selection Indices (DAX, MDAX®, SDAX® and TecDAX®), bolster the quality of member companies, and bring the selection criteria in line with international standards.
We caught up with Stephan Flaegel, Chief Product Officer, Indices and Benchmarks, at Qontigo, to ask him about the background and objectives of this historical index reform.
Stephan, Qontigo has taken on the biggest overhaul of DAX rules since the indices’ inception. What were the main drivers and objectives behind it?
“For over 33 years, the DAX Selection Indices have stood for transparency, predictability and replicability. Yet, the indices should always reflect the changing economic reality and must keep up with market developments. Therefore, it was time to take a very thorough look at the rulebook and strengthen the indices’ characteristics that have made them the undisputed gauges for the German market. We had three overarching objectives: enhance the flagship DAX’s composition quality, simplify its rules and bring it more in line with international practices.
“To gauge the opinion of the indices’ end users, we launched a market consultation through which we collected the responses of more than 600 market participants from all sectors – a great success, and key to ensure the broadest acceptance possible of the new rules. Almost all proposals were accepted with extraordinarily high support.”
Which new rules will have the greatest impact?
“They will all have a positive impact. Let me review them briefly. One new rule that has applied since last December is that new DAX candidates must show their profitability. Similarly, the obligation to timely publish audited annual financial reports, half-yearly financial reports and quarterly financial statements was introduced. This gives Qontigo more flexibility and the ability to act more timely in the face of breaches to financial reporting. In another new requirement, companies must meet certain recommendations of the German Corporate Governance Code regarding the formation and duties of an audit committee. At the same time, DAX Selection Indices membership is no longer restricted to companies of the Prime Standard segment of the Frankfurt Stock Exchange (FSE): a listing on the General Standard market is now sufficient. All these changes go a long way in enhancing the quality of businesses that will be part of DAX, which strengthens the value of DAX membership.
“In another key change, market capitalization becomes the only criterion in the ranking process. Stock exchange turnover is removed as a ranking criterion and replaced by a minimum level of liquidity. This methodology will be easier for all investors to understand – it’s an example of where the rulebook becomes much simpler, increases transparency and predictability, and matches the standard in other blue-chip indices.
“Finally, we also introduced a regular index review for DAX every six months instead of annually, to be able to reflect changes in capital markets more quickly.”
The DAX will grow from 30 to 40 constituents – isn’t that the biggest change?
“A broader benchmark means more sector diversification and a more comprehensive representation of the German stock market. That is a high-visibility change that most market participants welcome. The number of index constituents is only one of several parameters. Above all, we want the DAX to remain a high-quality index, to fulfil its function as the barometer for the German economy and of the highest accomplishments in Germany’s corporate world, and to remain investable as an underlying for financial products.
“The reform does not apply to DAX alone, but also to the other Selection Indices. In terms of composition numbers there is also a change in MDAX, which will be reduced from 60 to 50 components.”
And why 40 constituents for DAX?
“Qontigo believes that the DAX 40 is sufficiently liquid and investable and adequately represents the German blue-chip segment. We had received in recent years ongoing suggestions to increase the number of components in DAX. This was a proposal we put forward in the market consultation and the feedback was clearly in support for enlargement, across all stakeholder categories.”
One proposal, the exclusion from DAX of companies involved with controversial weapons, was rejected in the market consultation. Why?
“The market consultation showed that there are many different opinions and hardly reconcilable views around the question of whether environmental, social and governance (ESG) criteria should be part of a broad benchmark such as DAX. We have therefore decided not to implement this proposal and to address the ESG topic separately. We will, however, continue to seek a close dialogue with all market participants because sustainability remains one of the most important issues, for investors and for us.
“Separately, we have now launched two DAX indices that incorporate ESG criteria — the DAX® 50 ESG and DAX® ESG Target — which provide investors two distinct sustainability alternatives to the benchmark DAX and to the German equity market.”
Since you have brought them up, were the DAX 50 ESG and DAX ESG Target indices impacted by the rulebook changes?
“The DAX 50 ESG is a stand-alone, broad market-cap benchmark for German sustainable equities that sits alongside the DAX. The index was impacted from the reform in general, but not from the increased membership in the benchmark DAX. The DAX 50 ESG has always tracked the performance of the 50 largest, most liquid German stocks that have passed standardized ESG negative screens and feature comparably good ESG metrics. With the September 2021 review, selection rules in the DAX 50 ESG were changed along with those of DAX, therefore selection is now solely based on free-float market cap and ESG scores.
“The DAX ESG Target, on the other hand, is derived from DAX, has the same number of components as the benchmark, and aims to track it closely. Its composition will be affected by the changing stock universe of the benchmark DAX.”
September 20 is the date when the new DAX will replace the old one. What changes to the index level can we expect to see that day?
“Allow me to make the distinction here that this is not a new index, but the DAX of always with amended rules. You will see no changes or interruption to the index level as an effect of the additional constituents. The changes will occur as part of the regular index review, hence the index divisors will be adjusted to ensure index value continuity – as it happens at every chaining and every review.”
This all sounds like a huge project for Qontigo, and one with implications for many market participants. What’s your takeaway from all the work involved?
“That’s right. Such a reform is surely no small feat and has tremendous implications in many areas. Thousands of financial products, from ETFs to exchange-traded derivatives, certificates and structured products, use the DAX as underlying. And thousands of portfolios are affected.
“For Qontigo, this has been a cross-functional, firm-wide effort that engaged the Benchmarks R&D, Engineering, Sales and Operations teams and all others who work to ensure the indices tick seamlessly and faultlessly every day. We have discussed, analyzed, tested and controlled every single change at length, considering all implications for the headline indices and the dependencies of other derived indices. I am enormously proud of the outstanding teams who have made this ambitious effort a reality. All work was fully worth it: together, we have put the DAX index family in the best possible position for the future.”