We continue to see how the spotlight shines on the index providers.
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.”
Index constituents aren’t the only lobbyists. The authors also cite influence from the major index-fund companies: Vanguard, BlackRock, and State Street. 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.
