14 Index Providers
Fitchner
A silent revolution is happening in investing. It is a paradigm shift that will have a profound impact on corporations, countries and pressing issues like climate change. A silent revolution is happening in investing. It is a paradigm shift that will have a profound impact on corporations, countries and pressing issues like climate change. In 2019 there was a watershed in the history of finance. In the United States, the total value of actively managed funds was surpassed by passive funds. Globally, passive funds crossed US$10 trillion (£7.7 trillion), a five-fold increase from US$2 trillion in 2007.
This seemingly unstoppable ascent has two main consequences.
First, corporate ownership has become concentrated in the hands of the “big three” passive asset managers: BlackRock, Vanguard and State Street. They are already the largest owners of corporate America.
The second consequence relates to the companies that provide the indices that these passive funds follow. When investors buy index funds, they effectively delegate their investment decisions to these providers. Three dominant providers have become increasingly powerful: MSCI, FTSE Russell and S&P Dow Jones Indices.
A silent revolution is happening in investing. It is a paradigm shift that will have a profound impact on corporations, countries and pressing issues like climate change. Yet most people are not even aware of it.
In a traditional investment fund, the decisions about where to invest the capital of the investors are taken by fund managers. They decide whether to buy shares in firms like Saudi Aramco or Exxon. They decide whether to invest in environmentally harmful businesses like coal.
Yet there has been a steady shift away from these actively managed funds towards passive or index funds. Instead of depending on a fund manager, passive funds simply track indices – for example, an S&P 500 tracker fund would buy shares in every company in the S&P 500 in order to mirror its overall performance. One of the great attractions of such funds is that their fees are dramatically lower than the alternative.
In 2019 there was a watershed in the history of finance. In the United States, the total value of actively managed funds was surpassed by passive funds. Globally, passive funds crossed US$10 trillion (£7.7 trillion), a five-fold increase from US$2 trillion in 2007. ¿Le gusta lo que lee? ¿Quiere más?
This seemingly unstoppable ascent has two main consequences. First, corporate ownership has become concentrated in the hands of the “big three” passive asset managers: BlackRock, Vanguard and State Street. They are already the largest owners of corporate America.
The second consequence relates to the companies that provide the indices that these passive funds follow. When investors buy index funds, they effectively delegate their investment decisions to these providers. Three dominant providers have become increasingly powerful: MSCI, FTSE Russell and S&P Dow Jones Indices.
With trillions of dollars migrating to passive funds, the role of index providers has been transformed.
In the past, index providers only supplied information to financial markets. In our new age of passive investing, they are becoming market authorities. Deciding who appears in the indices is not just something technical or objective. It involves some discretion by the providers and benefits some actors over others. By determining which players are included on the list, setting the criteria becomes an inherently political activity.
The three dominant index providers’ income mainly derives from the funds replicating their indices, since they have to pay royalties for the privilege. MSCI, FTSE Russell and S&P Dow Jones will increase their role as a new kind of de facto global regulators.
This tightly interlinked group of three giant passive fund managers and three major index providers will largely determine how corporations tackle climate change. The world is paying little attention to the judgements they make, and yet these judgements look highly questionable. If the world is truly to get to grips with the global climate crisis, this constellation needs to be far more closely scrutinised by regulators, researchers and the general public.
Petry
Since the global financial crisis, there is a massive shift of assets towards index funds. Rather than picking stocks, index funds replicate stock indices such as the S&P 500. But where do these indices actually come from? This paper analyzes the politico-economic role of index providers, a small group of highly profitable firms including MSCI, S&P DJI, and FTSE Russell, and develops a research agenda from an IPE perspective. We argue that these index providers have become actors that exer- cise growing private authority as they steer investments through the indices they create and maintain. While technical expertise is a precondition, their brand is the primary source of index provider authority, which is entrenched through network externalities. Rather than a purely technical exercise, constructing indices is inher- ently political. Which companies or countries are included into an index or excluded (i.e. receive investment in- or outflows) is based on criteria defined by index pro- viders, thereby setting standards for corporate governance and investor access. Hence, in this new age of passive asset management index providers are becoming gatekeepers that exert de facto regulatory power and thus may have important effects on corporate governance and the economic policies of countries.
Index mutual funds have been available since the late 1970s and the first ETFs have been launched in the early 1990s. However, investors shunned them for a long time. But after the global financial crisis growth of index funds has accelerated mas- sively.
An unprecedented money mass-migration from active to passive funds, which is rational as most actively managed funds are unable to beat broad market indices over longer time periods but charge high fees.
One crucial, yet largely unstudied element of this new era is that index funds effectively delegate their investment decisions to index providers. Index providers are the firms that create and maintain the indices on which passive funds rely and to which asset managers have to pay fees if they use them.
Similar to passive asset management, which is dominated by the ‘Big Three’ of BlackRock, Vanguard, and State Street (Fichtner et al., 2017), the global index pro- vider industry is very concentrated. Just three firms, MSCI, S&P Dow Jones Indices (DJI) and FTSE Russell, hold a combined market share of almost 80%.
While global index revenues totaled a record US$2.7 billion in 2017, their profit margins that stand out as exceptionally high. MSCI reports an operating margin of over 60% for its index segment in 2018. Index providers operate in an oligopolistic industry, which has high barriers to competition.
During the last decade the big index providers have had much higher growth than most other financial companies, especially banks.
Index providers today occupy a position of growing private authority, with decision-making and standard-setting capabilities that are consequential in the global political economy. In the past, their indices primarily served informational purposes. An index such as the S&P 500 or the Nikkei was primarily a numerical representation of a particular stock market. Indices served as benchmarks against which analysts could gauge the performance of stocks. While the decisions of index providers had some impact on actively managed funds, the rise of passive investing transformed their role in a significant way. Today, they de facto steer capital with their indices as inclusions of firms or countries to an index can lead to inflows of billions of US$ while exclusions can cause large quasi- automatic outflows. Constructing indices is therefore not a purely technical exer- cise. Index providers have significant discretion in devising their methodologies.
The methodology of the pivotal S&P 500 index was changed at least eight times between 2015 and 2018. Underlying their seemingly technical exercise are decisional discretion and normative assumptions about ‘good’ corporate governance and ‘free’ markets. Index providers therefore play a role as standard-setters: their notions on what constitutes good corporate governance at the level of the firm and a favorable investment environment at the level of (national) markets helps or hinders firms and countries in attracting cap- ital, essentially deciding what is investment-worthy in global financial markets. This combination of standard-setting and legitimate decision-making power means that index providers have gained a position of private authority in capital markets with profound politico-economic consequences. Today index providers have become important counterparts for states.
Index providers increasingly are to equity markets what credit rating agencies are to bond markets, crucial ‘coordination service firms’ that exercise private authority and effectively set standards for the behavior of other firms and even countries
Their new authority was not delegated from the public sphere, but gradually emerged as part of a transformation of the index provider industry – from primarily supplying information about markets to becoming private authorities that are able to set standards on corporate governance and steer international capital flows.
Take for example FTSE Russell, S&P DJI and MSCI’s emerging market indices; the index providers’ recent decision to include countries such as China and Saudi Arabia to their indices is expected to result in a ‘seismic shift’ of over US$120 billion in active and passive fund flows by 2020.
Indices act as ‘prisms’ through which fund managers view the investible world.
Financial market indices are far from objective.
They represent ‘deliberate decisions’ made by index providers as every index is a managed portfolio whose composition is decided by the respective index provider.
While these simplified numerical representations might seem objective and technical, they are actually based on complex and (often contested) normative values. Moreover, proc- esses of index production are inherently subjective activities.
Standard-setting is always political.
Distance Governance
Indices and indicators have a governing effect on those that are being evaluated, incentivizing the individuals, companies or states that are being assessed to comply with the norms underlying those numerical representations, as better performance has positive ideational and material effects, enabling a form of ‘governance from a distance’
Critical gatekeepers that exert de facto regulatory power.
The emergence of private authority through the retreat of the state, which provided a space for private actors such as firms to exercise authority.
Questions such as the public regulation of index providers.
Private authority is inherently relational, produced and reproduced through ongoing interactions between the authority and non-authorities, where the formers’ decisions are considered as legitimate by the latter
Rather than coercion or self-interest, legitimacy is a ‘normative belief by an actor that a rule or institution ought to be obeyed’ and is based on how the authority is ‘perceived’ by non-authoritarian actorsRather than coercion or self-interest, legitimacy is a ‘normative belief by an actor that a rule or institution ought to be obeyed’ and is based on how the authority is ‘perceived’ by non-authoritarian actors.
Three conditions for index provider authority. First of all, technical expertise to construct an index is a necessary – but not sufficient. Second condition; crucial for index provider authority is their brand recognition, or more specifically the trust that the international investment community puts in their brands. ‘Authority is socially constructed’ and is ultimately based on trust, which in turn is based on reputation. The big three index providers are ‘brand managers’ : ‘at the end of the day, those products are homogeneous and exchangeable. It’s like water, there are small differences why Evian is more expensive [ … ]. Those are minimal differences, but the price tags are very different! A third condition that underpins index provider authority lies in a set of net- work externalities that reinforce the authority of the major index providers. As first movers they have in effect ‘captured’ different national (e.g. S&P 500 or FTSE 100) and regional (Euro Stoxx 50) market segments with their indices. These network externalities entrench the authority that leading index providers derive from their brands. With these three conditions in place, index providers have become private authorities in financial markets.
The authority of rating agencies developed within and was enabled by changing socio- economic structures, i.e. the growth of capital markets and the decline of banks as allocators of credit, which created a demand for rating agencies’ services for the functioning of the then disintermediated structure of finance.
Authority is best understood as an effect of these circumstances, rather than as an entity or a characteristic of an actor or institution’ and ’its existence is therefore not func- tional, [ … ] but always contingent on time, place, and circumstance.
Indices had at least some influence on asset managers as an deviation from the relevant index could be conceived as a kind of risk management metric. However, indices only loosely anchored the asset allocation as most fund managers had the discretion to choose both the degree of replicating the index as well as the time period for doing so.
Changed fundamentally with the rise of passive investing in the mid-2000s. Index providers began to influence capital flows in an immediate and comprehensive way. Being a central component of the index funds ecosystem conferred them – gradually and only as a side-effect of their business model – a position of growing private authority in financial markets.
The money mass-migration towards passive investments, which significantly increased the nascent authority of index providers as evermore funds directly tracked their indices. Whereas in the past indices only loosely anchored fund holdings around a baseline, now they had an instant, ‘mechanic’ effect on the holdings of passive funds, ‘steering’ cap- ital flows. Increasingly, investments were not actively managed by fund managers but passively invested into index mutual funds and ETFs
This makes sense as the vast majority of actively managed funds have not been able to beat benchmark indices over longer periods of time, while charging substantially higher fees than index funds.
In order to track the performance of ‘the market’, passively managed funds replicate stock market indices such as the S&P 500 or the MSCI World. Rather than trying to generate ‘alpha’ and outperform the market by pick- ing stocks, these passively managed funds aim to generate ‘beta’, simply replicat- ing the performance of specific stock markets while minimizing fees.
By investing in an index, passive investors delegate decision-making about where to invest to index providers. Index investing thus represents a form of ‘delegated management’ and every discretionary decision by index providers has a ‘flow through effect on the investor’s portfolio’
A substantial proportion of equity funds that officially are actively managed funds (and therefore charge higher fees than index funds) but actually do not devi- ate much from their benchmark indices. This is referred to as ‘closet indexing’ or ‘index hugging’, and it is estimated that in the EU between 5-15% of all equity funds could fall into this category (ESMA, 2016). Therefore, the rise of passive management also increases the authority of index providers vis- a-vis active man- agement because by steering evermore passive capital index decisions now mechan- ically move ever larger parts of the markets, creating a ‘pull effect’ that actively managed funds need to follow
Hedge funds and sovereign wealth funds (SWFs) generally have low degrees of rep- licating indices (one exception is the Norwegian SWF, which almost invests like a global ESG 5 index fund) and are fully discretionary to follow any index modifica- tion.
Indices no longer merely measure markets. They move them.
Far from simply providing information on ‘the market’, index providers now offer a variety of cus- tomized branded products, by either tweaking existing benchmarks or repackaging proprietary trading strategies into indices which enable the functioning of (passive) asset management capitalism.
The relationship between index providers and asset managers is intriguing. On the one hand, asset managers depend on the large index providers to create their products that are attractive to investors. On the other hand, they have an interest to reduce the fees they have to pay for using indices. In theory, there are two ways for competition to emerge in the index industry: through new index providers and through self-indexing by asset managers. However, both have so far not been able to break the oligopolistic market structure.
It is further difficult for challenger indices to gain benchmark status as network externalities entrench the authority of the big index providers.
Index providers not only decide to include particular firms, they also make decisions on in- and exclusions of entire markets, steering capital with important politico-economic implications for states.
While many indices are strictly rule-based and thus only influence companies indirectly, some indices – including the S&P 500, the world’s most-tracked index – have com- mittees that make discretionary, less rule-based decisions. While the majority of inclusions is rather mechanical and influence is indirect, it is not uncommon that index decisions target individual firms to set a ‘precedence’ on a particular issue that then gets incorporated into existing methodologies.
It has become standard practice for the majority of key global stock indices to use only the market capitalization of firms for calcu- lating the weight of companies. Market capitalization primarily derives from the (future) profits of corporations. Even though that has changed somewhat in the last decades, profit maximization is still not the exclusive goal of corporations from countries such as France, Germany and Japan.
‘reluctant regulators’
‘We’re not activists. We’re setting the minimum standards that investors generally will accept, and our role is to build consensus amongst that investor community as to what that minimum standard should be’.
The three big index providers are therefore best seen as consensus-building agents that aggregate their own interests with those of asset managers from developed economies, i.e. mainly from Anglo- American countries.
Index providers have become de facto private standard-setters over corporate governance.
By reclassifying individual countries, index providers effectively redraw the borders of markets. Index providers set out the criteria that decide which countries are ‘investment-worthy’.
Index providers decide whether to include countries into their indices and whether to classify them as ‘frontier’, ‘emerging’ or ‘developed’ markets. 8 By additionally putting countries on watchlists for such inclu- sions, exclusions or reclassifications, index providers create incentives for states to comply with their rules.
MSCI in effect controls the definition of which countries are “emerging markets. Criteria are set out in MSCI’s Market Classification Framework, com- prising three elements: economic development; size and liquidity; and investor access. Economic development is not crucial as a criterion, neither are the size and liquidity requirements (only 2-5 companies need to meet minimum requirements). Investor access is the dealmaker/breaker for country classifications, and it is on this that most indexing decisions are based
While index decisions about company inclusions are often more indirect and not targeted at indi- vidual companies, in the case of country reclassifications index providers take a much more proactive role. As the following cases demonstrate, these deci- sions have enormous consequences for states and their national stock markets.
MSCI has a quasi-regulatory function – ‘even though MSCI is not a regulator, companies need to abide, to respect their rules’.