Few ideas hold sway over U.S. markets and the economy today more than the wisdom of passive index investing. Vanguard founder Jack Bogle’s once-eccentric belief — that an individual investor’s best recipe for long-term gains is a diversified portfolio of securities and a relentless focus on keeping fees low — is now the market’s most widely held philosophy.
It wasn’t just the strength of Bogle’s ideas, however, that created an environment where funds that passively track a broad market index like the S&P 500
now manage more than half of the roughly $11 trillion invested in domestic equity funds. A series of legal and regulatory changes over the past 50 years laid the foundation for passive investing’s dominant role in today’s markets, and the Securities and Exchange Commission may now be set to rein in some of the unintended consequences that previous reforms wrought, according to interviews with current and former regulators.
“Fundamentally, millions of American families don’t choose what they invest in, an index provider chooses what they invest in,” Robert Jackson, who served as an SEC commissioner from 2018 to 2020, told MarketWatch.
“The choice to include or not include a company in the S&P 500 moves billions of dollars of American families’ money in and out of that company,” he added. “That choice is subject to very little oversight and it raises potential conflicts of interest that have never been addressed by financial regulators.”
The Center for American Progress, a left-leaning think tank, issued a report Friday, previewed exclusively to MarketWatch, that argues that the SEC and other financial regulators “should adopt a comprehensive regulatory regime for financial products tied to indexes,” including setting minimum standards for governance of indexes and mandating transparency regarding methodology, licensing fees and potential conflicts of interest.
The SEC, which is headed by Gary Gensler, may soon act on this recommendation. In its recently published regulatory agenda, the agency said it would consider asking the public to comment on the role index providers play in the asset management industry.
SEC Commissioner Caroline Crenshaw told MarketWatch in a statement that she supports the agency investigating the topic.
“Trillions of dollars are tied to the performance of indexes, yet it’s not always clear how indexes are constructed or governed,” said Crenshaw, a Democrat. “Investors who depend on indexes for their retirement or their children’s education deserve to know how their money is being invested and that the investment is in their best interest. The commission should consider ways to ensure these goals.”
Index membership for sale?
Andres Vinelli, vice president for economic policy at CAP and the former chief economist at the Financial Industry Regulatory Authority, pointed to new research that indicates index providers could be adjusting their inclusion criteria to benefit issuers with which they have a financial relationship.
In November, academics Kun Li and Xin Liu of Australian National University and Shang-Jin Wei of Columbia University published research which argued that S&P Global’s index division has significant discretion over which firms ultimately end up in the S&P 500 and that “the discretion is often exercised in a way that encourages firms to buy fee-based services from the S&P.”
“This happens to issuers that are companies, but could happen with whole countries,” Vinelli said in an interview. “If you’re managing a bond fund, countries might want to have their bonds in your fund and there might be levers countries can use to induce you to do that.”
S&P disputes the accuracy of the report.
“This non-peer-reviewed paper is flawed and contains a number of misleading and inaccurate statements about the S&P 500, its methodology and eligibility rules, and the impact of index inclusion,” April Kabahar, a spokesperson for S&P Global
said in a statement to MarketWatch. “S&P Dow Jones Indices and S&P Global Ratings are separate businesses with policies and procedures to ensure they are operated independently of one another. Our Index Governance segregates analytical and commercial activities to protect the integrity of our indices.”
The Wall Street Journal reported in 2019 that MSCI Inc.
the provider of the closely followed Emerging Markets Index, was pressured by the Chinese government to include domestic Chinese stocks in the index. The report cited unnamed sources which said that the Chinese government directed asset managers in the country to withhold business from MSCI after it had previously declined to include those stocks. MSCI said in response to the article that its index-inclusion process is run by a separate division than its commercial operations and that its criteria are public and transparent.
Investment advising in disguise
SEC rules require that that mutual funds select a benchmark index and to report the fund’s performance relative to that index, and this mandated practice of benchmarking has produced a legally enshrined source of revenue for index providers, who charge fund managers licensing fees.
Adriana Robertson, a professor of finance and law at the University of Toronto, has analyzed the methodology of more than 600 equity indices that U.S. funds benchmark themselves to. She found that the vast majority of indexes serve as a benchmark for just one fund, reflecting the fact that index providers often create bespoke indices at the direction of fund companies, which offer products that track these tailor-made compilations of securities.
“They are being created really for the use of the fund,” she said in an interview, adding that this practice of stock selection on the part of index companies should force the SEC to consider them investment advisers and regulate them as such. If the SEC were to enforce the law, she added, index providers that act like investment advisers would need to register with the SEC and assume a fiduciary responsibility to their clients. “Right now this is a completely unregulated relationship,” Robertson said.
Robertson argued that this loophole creates an uneven playing field between active managers who want a relationship with an adviser and index funds that outsource that function to index providers. “Either we think these rules are doing something helpful, or we don’t,” she said. “And if they’re not doing anything, or they’re so burdensome that the costs outweigh the benefits, we shouldn’t subject anyone to them.”
This loophole is not the only way in which financial regulators have encouraged the growth of index investing. Michael Green, portfolio manager and chief strategist at Simplify Asset Management, says that a series of regulatory and legal changes over the decades has been a necessary component in the widespread adoption of index funds by the investing public.
Green points to a 1994 decision by former SEC Chairman Arthur Levitt to not enforce a provision of the 1940 Investment Company Act that would had prevented index fund providers from using derivatives to allow them to better track the performance of indexes. A law passed in 2006 aimed at bolstering Americans retirement savings created incentives for more workers to join 401(k) plans and for employers to choose index funds as the default offering. Today, Green says, nearly 100% of all new 401(k) money entering the market does so through index funds.
“We have a cumulative dynamic where a lot of small policy changes, each one of them seemingly inconsequential, facilitated the growth of passive management to this point,” Green told MarketWatch.
The problem, Green says, is that passive flows of retirement savings into market indexes like the S&P 500 means that billions of dollars every week flow into the market in a manner that is totally indifferent to the fundamentals of the underlying businesses. Because the S&P 500 is weighted by market capitalization, that means savers are not just blindly buying that collection of stocks, but are doing so in proportion to how much money has already flowed into those names, leading to a situation where just five stocks account for a record 23% of the entire market.
These one-way bets increase correlation between stocks on the index and reduce the advantages that can be gained from thoughtful stock picking, creating a snowball effect of ever greater interest in passive vehicles. Green argues that as baby boomers continue to age out of the workforce and stop adding new money to 401(k)s, it could create a liquidity crisis wherein there are few buyers for what new retirees are selling.
“Changes will be made, but it will require a crisis,” Green said. “Increasingly market participants sense that something is off, but to make a significant regulatory change that would change in the investment patterns, the product availability and the fees being charged — it’s really hard to make that change.”
Others argue that while the SEC and other regulators should be watching to understand the systemic implications of these trends, they should also keep in mind the benefits that low-fee index investing have brought the American public.
“Index funds are very inexpensive, and say what you want about the industry, but at the end of the day they deliver access to the most robust growing markets in history,” for miniscule fees, said former SEC Commissioner Jackson “We’ve given access to the market that millions of people wouldn’t have had thirty years ago. That’s an enormous achievement, but what we haven’t done is grapple with the consequences.”