The Spotlight Turns on Index Providers (Part 1)

They have quietly acquired huge powers--and responsibilities.

John Rekenthaler 24.02.2020
Facebook Twitter LinkedIn

Into the Glare

Index funds have been heavily criticized. 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.

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.

In part 2 of this article, we will continue to see how the spotlight shines on the index providers.

Facebook Twitter LinkedIn

About Author

John Rekenthaler  is vice president of research for Morningstar.

© Copyright 2024 Morningstar Asia Ltd. All rights reserved.

Terms of Use        Privacy Policy        Disclosures