Over the last decade, index providers have been facing increased scrutiny into their operations as concern has been growing over the power they hold over markets. Whilst regulated in Europe since 2018, the situation differs in the US. Technically classed as data publishers, index providers face little scrutiny from financial regulators, leading some to question if change is needed. At the same time regulation came into force in the EU, Jenna McCarthy, a law student at Vanderbilt University, published the paper “Benchmarking the World: A Proposal for Regulatory Oversight of Stock Market Index Providers” in which the case was made for the US to follow in Europe’s legislative footsteps. Since then, further calls have been made by journalists and economists, but to little effect. Consequently, questions have arisen as to what exactly index providers do, how they do it, and why some see the need for regulation.
Put simply, an index is a measurement or indicator. In the context of a stock market, it is a hypothetical portfolio that aims to measure the performance of a particular industry, sector, or economy. Some, such as the FTSE and S&P 500, measure whole countries’ stock markets whilst others, such as the Morgan Stanley Capital International (MSCI) Emerging Markets Information Technology Index for example, measure narrower, defined areas. Index providers, the companies that create and maintain them, make money when investment funds pay licensing fees to use them. Since an index cannot be directly invested in (it’s a hypothetical portfolio) “tracker funds” fulfil this role. These are passively managed investment funds that mimic the returns of an index, allowing investors to gain exposure to whatever it is the index measures. These funds pay a fee to the index provider in the form of a percentage of assets under management (AUM), usually around 3-4 basis points. It follows therefore, that the better an index performs, the more funds there may be that use it, as well as potentially more money flowing into those that do. Thus, the provider stands to gain a greater profit if the index performs well. This could be said to constitute a potential conflict of interest. However, if indices are merely measurements, then the means by which to exploit this incentive initially appear not to exist. Providers may benefit from growing markets, but they don’t on the surface appear capable of influencing investment decisions, and so any argument for a conflict of interest initially seems flawed.
With deeper analysis, however, there may potentially be some weight to the argument. Data from the World Bank and Index Industry Association shows that there are currently 70x more stock market indices than public companies worldwide. Under this context, the potential for overlap is seemingly unavoidable. With this comes the consequence that two indices apparently measuring the same thing are highly likely get differing results. This creates a degree of subjectivity, and the potential for biased judgements. If there is ambiguity in how a market or market sector is measured, then providers seeking monetary gain may be able to act on the incentive that exists to distort the indices they provide. Research in McCarthy’s paper demonstrates that this has actually already occurred:
“For example, in 1999 the DJIA [Dow Jones Industrial Average index] committee added tech companies like Microsoft at the height of the tech bubble, and removed Chevron and Goodyear to make room, but then added Chevron back to the DJIA years later when its stock rose 60 percent.”
They conclude with: “it’s clear … decisions about the companies that make up an index are being made by small groups of people who stand to receive financial benefits from their decisions”. This points to the suggestion that index providers may be capable, and willing, to use their discretionary authority in a way that reduces investors’ trust, diminishes market transparency, and harms the integrity and reliability of the indices they create – all in the pursuit of profit. A poignant reminder of what can happen when indices are manipulated can be seen in the LIBOR scandal of 2012. Traders acting on a conflict of interest distorted the value of the LIBOR (an interest rate index) culminating in market distortions that, while difficult to estimate, were of the magnitude that roughly 9 billion USD in fines was issued by the UK and USA. Ultimately, regulation has the potential to reduce if not remove the dangers that can arise if conflicts of interest are allowed to be realised.
With laws already in place governing the activity of index providers in Europe, American providers are already required to comply with some legislation, if operating in Europe. This suggests the process of implementing US based regulation may not be as difficult as had it been from scratch, and as such, any increase in operating costs for American index providers arising from new regulation may be less significant. Furthermore, the impact on investors is likely to be even less so. Global competition amongst passive funds, which use indices, has increased dramatically over the last decade, culminating in a relentless drive to push investor costs as low as possible. Therefore, even if index providers push any increased costs onto funds through the licensing fee, it is unlikely that funds will break from their so called ‘price war’ in order to push it onto investors.
In conclusion, index providers appear to be capable and willing to act in a manner more akin to investment managers than might be expected of them by the investors they serve. Whilst the effectiveness of the relatively new European legislation in curbing this is expected to reveal itself over time, it seems likely that introducing new regulations in the USA has the potential to provide reassurance to investors and contribute to more transparent markets where the integrity and reliability of indices is no longer in question. In terms of the relevance of the current situation to investors globally, any change, be it greater regulation in the case of Europe or entirely new regulation in the case of the USA, appears unlikely to be the cause of much concern regarding fees. Taking a broader view, more accountable and better regulated index providers seem a net benefit to those who rely on their accuracy and ability to reflect, without bias, different aspects of the financial markets. However, it is worth mentioning the notable exception of passive investment funds, who could potentially face increased licensing costs as a consequence.
By David Bendle
Sector Head: James Float