The SEC’s next regulatory target could be index providers

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Few ideas dominate the US markets and economy today than the wisdom of passive index investing. The once cynical belief of Vanguard founder Jack Bogle—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. Is.

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This was not the only strength of Bogle’s ideas, however, it created an environment where funds passively track broad market indices such as the S&P 500 SPX,
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manage now more than half About $11 trillion was invested in domestic equity funds. A series of legal and regulatory changes over the past 50 years have laid the foundation for passive investing’s dominant role in today’s markets, and the Securities and Exchange Commission may now be ready to rein in some of the unintended consequences that past reforms have created in interviews. were done accordingly. With current and former regulators.

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“Basically, millions of American households don’t choose what they invest in, an index provider chooses what they invest in,” Robert Jackson, who served as SEC commissioner from 2018 to 2020, told Businesshala.

“The choice of whether or not to include a company in the S&P 500 moves billions of dollars of American households’ money in and out of that company,” he said. “This option is subject to little oversight and poses a potential conflict of interest that has never been addressed by financial regulators.”

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Center for American Progress, a left-wing think tank, issued a report Friday, previewed exclusively for Businesshala, argues that the SEC and other financial regulators should “adopt a comprehensive regulatory regime for index-bound financial products”, including setting minimum standards for the governance of indexes and This includes mandating transparency about methodology, license fees and potential conflicts. Of interest.

The SEC, headed by Gary Gensler, may soon act on this recommendation. recently published in regulatory agenda, the agency said it would consider asking the public to comment on the role of index providers in the asset management industry.

SEC Commissioner Carolyn Crenshaw told Businesshala in a statement that she supports the agency investigating the matter.

“Trillions of dollars are tied to index performance, yet it is not always clear how indexes are created or governed,” said Crenshaw, a Democrat. “Investors who depend on the Index for their retirement or the education of their children deserve to know how their money is being invested and that investment is in their best interest. should consider.”

Index membership for sale?

Andres Vinelli, vice president of economic policy at CAP and former chief economist for the Financial Industry Regulatory Authority, points to new research that indicates index providers may adjust their inclusion criteria to benefit the issuers with whom they have financial relationships. Is.

In November, academics Kun Lee and Shin Liu of the Australian National University and Shang-Jin Wei of Columbia University published research who argued that S&P Global’s index division has significant discretion over which firms ultimately end up in the S&P 500 and that “prudence is often exercised in a way that encourages firms to purchase fee-based services from the S&P”. does.”

“It happens with issuers that are companies, but can happen with entire countries,” Vinelli said in an interview. “If you’re managing a bond fund, countries want to hold their bonds in your fund and there may be leverage countries can use to induce you to do so.”

S&P disputes the accuracy of the report.

“This non-peer-reviewed paper is flawed and contains many misleading and false statements about the S&P 500, its methodology and eligibility rules, and the impact of index inclusion,” said April Kabahar, spokesperson for S&P Global SPGI.
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said in a statement to Businesshala. “The S&P Dow Jones Index and S&P Global Ratings are separate businesses whose policies and procedures ensure they operate independently of each other. Our index governance incorporates analytical and commercial activities to protect the integrity of our indexes. separates.”

wall street journal Reported in 2019 that MSCI Inc. MSCI,
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The provider of the closely followed emerging market index was pressured by the Chinese government to include domestic Chinese stocks in the index. The report cited unnamed sources as saying that the Chinese government had instructed asset managers in the country to stop trading with MSCI, as it had previously refused to include those shares. MSCI, in response to the article, said that its index-inclusion process is run by a different division than its commercial operations and that its criteria are public and transparent.

investment advice in disguise

SEC regulations require that mutual funds select a benchmark index and report the fund’s performance relative to that index, and this mandated practice of benchmarking has created a legally implied source of revenue for index providers, Fund managers who charge a license fee.

Adriana Robertson, Professor of Finance and Law at the University of Toronto system analysis Out of over 600 equity indices that US funds benchmark themselves. She found that the vast majority of indexes serve as benchmarks for just one fund, reflecting the fact that index providers often create bespoke indexes on the direction of fund companies, which offer products that complement these types of securities. Tailors track the compilation.

“They’re actually being created for the use of the fund,” she said in an interview, adding that this practice of stock selection on behalf of index companies should prompt the SEC to consider investment advisors and regulate them as such. should be forced. If the SEC were to enforce the law, he said, index providers who act like investment advisors would need to register with the SEC and assume a fiduciary responsibility to their clients. “Right now it’s a completely erratic relationship,” Robertson said.

Robertson argued that this loophole creates an uneven playing field between active managers who want a relationship with an advisor and index funds who outsource that task 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 cumbersome that the costs outweigh the benefits, then we shouldn’t subordinate anyone to them.”

systemic risk

This loophole is not the only way financial regulators have encouraged the growth of index investing. Michael Green, portfolio manager and chief strategist at Simplify Asset Management, says a series of regulatory and legal changes over the decades have been a necessary component of the widespread adoption of index funds by the investing public.

Green points to a 1994 decision by former SEC Chairman Arthur Levitt not to implement a provision of the Investment Companies Act of 1940, which prohibits index fund providers from using derivatives to better track the performance of indexes. be allowed to do. A law passed in 2006 aimed at boosting Americans’ retirement savings encouraged more workers to join 401(k) plans and for employers to choose index funds as a 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 there are lots of small policy changes, each of them seemingly inevitable, to the point facilitating the development of passive management,” Green told Businesshala.

The problem, says Green, is that the passive flow of retirement savings into market indexes like the S&P 500 means that billions of dollars flow into the market each week in a way that is completely indifferent to the fundamentals of the underlying businesses. Because the S&P 500 is weighted by market capitalization, it means that savers are not only buying a collection of stocks blindly, but are doing so in proportion to how much money is already flowing into those names. , leading to a situation where there are only five stock accounts. A record 23% of the entire market.

These one-sided bets increase the correlation between the stocks on the index and reduce the gains that can be derived from discreet stock picking, creating a snowball effect of greater interest in passive vehicles. Green argues that as baby boomers drop out of the workforce and stop adding new money to 401(k)s, this could create a liquidity crisis in which there are few buyers to sell to newly retirees. Huh.

“Changes will be made, but it will require a crisis,” Green said. “Increasingly market participants think something is off, but to make a significant regulatory change that will change investment patterns, product availability and the fees charged – it is really difficult to change that.”

Others argue that while the SEC and other regulators should look to understand the systemic effects of these trends, they should also take into account the benefits that low-fee index investing has brought to the American public.

“Index funds are very cheap, and say what you want about the industry, but at the end of the day they provide access to some of the strongest growing markets in history,” for a nominal fee, …

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