The spotlight turns on index providers

Note: Morningstar is itself an index provider, although mentioned only in passing by the referenced paper.

Index funds have been heavily criticized. This column has documented several such attacks. Index funds warp equity prices by rewarding securities that are held by the major indexes and penalizing those that are not. They have inflated a stock market bubble. They are slothful (or even damaging) corporate stewards.

In contrast, companies that create and provide indexes have operated largely in the shadows. Their products appear in nightly summaries of stock market performances, as well as in the names of many funds, but the firms themselves haven’t appeared in many negative headlines. Vanguard takes the heat, not MSCI.

That may be changing, thanks to a recent paper called “Steering capital: the growing private authority of index providers in the age of passive asset management.” (Johannes Petry, University of Warwick; Jan Fichtner and Eelke Heemskerk, University of Amsterdam.) Note the authors’ initial verb. Index providers do not assist in the neutral task of allocating capital. Rather, they steer it.

Unintended effects
I agree with the authors. Neutrality might be possible if indexes did not attract cash, but since they do, the only index that does not steer capital is the index that does not exist: the entire global financial market. Any subsets, even if very broad (such as “global equities” and “global fixed-income”), inevitably create distortions because those subsets do not attract assets in proportion to their market weights. Unintentionally, passive investors skew capital allocations by favoring some asset classes over the others.

Other cases of index-provider involvement are more obvious. Standard & Poor’s does not place the 500 largest companies into its S&P 500 index; rather, it chooses from eligible candidates. The selection committee’s proceedings are not public record. To cite another example, somebody must decide which stock markets are “emerging” and which are not. That somebody is the index provider.

More active yet are the “strategic beta” indexes that advocate investment decisions. Buy low-volatility stocks because they have better risk/return profiles than their higher-volatility rivals. High-dividend equities outperform those with lower dividends. Weighting securities equally is preferable to market-weighting them.

The list could fill several weeks’ worth of columns (easy work, but dull reading). You get the point.

Market impacts?
One potential market consequence has already been mentioned: Flows into index funds affect asset-class prices. However, index providers--along with their partners, the companies that offer index funds--also influence security prices within asset classes and not necessarily fairly. After all, stocks from companies that are recently struggling are favored by index-fund inflows just as much as those that have been succeeding. That doesn’t seem right.

Unfortunately for this argument, it is difficult, if not outright impossible, to quantify the concern. It may be that active investors quickly arbitrage away the inefficiencies that come from indexing, or it may be that discrepancies persist. We struggle to understand. What is clear, though, is that to the extent that the concerns are real, they are caused by the combination of index providers, index funds, and index investors. If there is to be blame, all three parties are guilty.

The sausage factory
As the authors show, index constituents react variously to the index providers’ decisions. Sometimes they capitulate. Unilever (UNLVF) scrapped a plan to consolidate its headquarters in Amsterdam because doing so would have led to its stock being removed from the FTSE 100 Index. The tail thoroughly wagged the dog--and harmed the business to the extent that moving the headquarters would have been a benefit. (Once again, it’s difficult to know.)

Other times, the subjects do not submit meekly, and they pressure the index providers to change their minds. For example, Chinese officials wrangled with the ratings agencies about how their nation’s stocks should be treated. As the authors noted, recent decisions by MSCI and FTSE Russell to add China A-shares to their primary emerging-markets indexes, despite China’s restrictions on outsider ownership of shares, was not a “technical exercise but a highly political process.” You’d better believe it.  

Index constituents aren’t the only lobbyists. The authors also cite influence from the major index-fund companies: Vanguard, BlackRock (BLK), and State Street (STT). Those firms have various reasons, from operational to marketing to investment, for preferring some index constructions to others. To what extent do the index providers’ largest customers shape their offerings? To what extent should they?

The authors believe that as “gatekeepers,” the index providers tend to have the upper hands in their negotiations--an attitude that is echoed by the Financial Times’ story about their paper, “The index providers are quietly building up enormous powers.” Perhaps, though one should not discount the other parties’ contributions. At any rate, the upshot is the same: Index providers, in conjunction with their constituents and clients, “influence investment decisions and corporate governance norms.”

Further research
The authors, quite properly, refrain from recommending proposals for change. After all, who is to say that the process of global capital allocation was better before index providers came to power? Instead, the paper concludes by suggesting a three-part research agenda:

1) Index-construction decisions

What occurs in the room where it happens? The authors wish to know more about how the providers weigh each party’s interests, as well as the extent to which index-provider decisions reflect competitive concerns rather than strictly investment issues. To answer these questions, they suggest a “broad interview-based study.”

2) Corporate-governance standards

The index providers are “de facto standard-setters” for corporate governance. Have they been change leaders, change followers, or something in between? Does one firm (the authors suggest perhaps MSCI) establish rules that the other providers tend to follow? An analysis of how each company’s index methodologies have evolved over time could answer such questions.

3) National relationships

Particularly within the emerging markets, the index providers’ treatment of issues such as investor access and financial reporting affects how nations regulate their financial markets. The authors believe that combining a quantitative study with “interview-based case studies of individual countries” would help in understanding the providers’ roles.

These are sensible recommendations, offered constructively. It would be useful for the appropriate parties (global regulators?) to adopt them.