Index regulation is tricky but necessary
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Alex Matturri is the former chief executive of S&P Dow Jones Indices.
Earlier this week the Securities and Exchange Commission announced that it was exploring whether index providers should be regulated as “investment advisers” — just like any money manager. It was a bombshell that many have seen coming.
Here’s what SEC chair Gary Gensler said in the press release announcing a request for comment on the regulatory status of index companies, model portfolio providers and pricing services:
In recent decades, the use of information providers has grown, changing the asset management industry. The role of these information providers today raises important questions under the securities laws as to when they are providing investment advice rather than merely information. In order to help the Commission determine when — and under what facts and circumstances — these providers are giving investment advice, the Commission seeks information and public comment to help guide our approach.
Index providers are the main target. Companies that produce financial indices like the S&P 500, the Russell 2000 or the MSCI World index have in the US avoided regulation by operating under the “Publishers’ Exemption”, which originally was intended to shield newspapers and newsletter writers.
After all, many index providers did start within publishing businesses or exchanges, as a fairly small information service to customers. The courts have therefore felt comfortable that index providers were not providing investment advice when they created benchmarks.
The benchmarks were supposed to merely reflect the market, rather than constitute a recommendation of what securities to buy, and were offered to a broad audience rather than directly to a client.
The regulatory philosophy in the US has therefore been to regulate the index product but not the index provider.
This approach has worked well for many years, but is this the case any more?
There are several factors which have led to the SEC reviewing whether index providers should be regulated. But the biggest is the tremendous growth of passive index-based investment products.
The Investment Company Institute now estimates that 16 per cent of the entire US stock market is held by index funds, outstripping the 14 per cent owned by traditional actively-managed funds.
Some recent academic research claims that this is beginning to warp the efficient functioning of markets.
There are many variations of this theme, such as index trades being ‘informationless’ and thus impacting price formation; indexed portfolios being trend-followers that just buy more of the winners regardless of company fundamentals; and that there is an ‘index effect’ which results from a stock being added to major indices such as the S&P 500 or Nasdaq 100.
I maintain that these fears are overblown. But one cannot argue with the fact that there have been an enormous shift into index-based products such as ETFs, index funds and structured products, along with elevated trading of index derivatives. Financial indices matter more than ever before.
One aspect the SEC is probably focused on is the growth of new custom, thematic, defined outcome and ESG indices used in the ever-growing number of investment products offered to investors. These indices have much more discretion in their design, and rather than just measuring a segment of the market based on market capitalisation are being developed to achieve a desired investment outcome.
This raises the question of whether index providers are providing some form of investment advice and should no longer operate under the Publisher Exemption.
While I feel an appropriate regulatory regime should be welcomed by index providers, the SEC needs to ensure that its scope allows for the investor benefits from cheap index-based investment products continue to blossom.
In Europe and other global jurisdictions, the regulatory process is well under way although the approach taken is quite different. After the Libor scandal, Europe took a legislative approach and enacted the EU Benchmark Regulation (BMR). This applies to almost all providers of indices, and all indices offered for use in Europe fall under the regulation. There is no distinction based on the type of index or, with a few exceptions, the product category.
One problem in the US is that not all investment products fall under SEC’s jurisdiction. The final result could be an unholy mess where some index providers are more heavily regulated while others escape entirely.
For example, it is possible that an index provider that offers an benchmark used for futures contract would not fall under the regulation — since futures are regulated by the CFTC — but when the same index used as the basis of an ETF it would be encompassed by any SEC regulation. The same problem would occur with an indexed bank collective trust, as these do not fall under the SEC’s purview, while a classic 40 Act fund does.
There are many other potential complications. While it is not clear exactly what the SEC is focused on, the press release references “whether, under particular facts and circumstances, information providers are acting as investment advisers”. But it seems that the Commission is interested in only certain types of indices, and is pretty comfortable with the way broad-based gauges such as the S&P 500 are maintained.
If the SEC’s focus is on bespoke and custom indices (they draw a distinction between the two) or narrower indices such as factors, thematics, defined outcome or an ESG benchmark, a major definitional issue arises. The problem with this approach is where do you draw the line between what types of indices result in the index provider having to be regulated?
It will not be easy to sort indices into regulated and unregulated buckets. Using the type of index as a deciding factor can lead to an uneven playing field, with some index providers falling under the regulatory scheme while others will not. The European approach of including all indices and all providers is more appropriate.
The fact that the SEC is looking at the regulation of index providers is a positive. It is one of the only segments of the capital markets not regulated in the US. Given the swelling importance of index providers, regulatory oversight is necessary. But it needs to be equally applied.
Currently, the larger independent index providers operate very differently than many smaller ones, or internal benchmark providers at some asset managers. As they have a global business focus, the big providers have structured their operations and governance structures to adhere to IOSCO’s Principles for Financial Benchmarks, and are working to comply with the EU BMR.
Generally, these index providers have clear governance policies and strict procedures in place, which include publishing methodologies and public consultations before those methodologies are changed. The same cannot be said for all index providers.
The SEC review is a healthy step but any final regulation will be better served if it applies to all index providers and all indices.
This may be complicated as not all investment products fall under the SEC’s regulatory span. But taking a leaf out of Europe’s approach and aligning with its BMR will ensure index providers continue to serve the capital markets in the best possible way.
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