BIG FINGERS: FINANCIAL-MARKET INDEX-MAKERS ARE GROWING IN POWER

Big fingers

Financial-market index-makers are growing in power

Their role is facing greater scrutiny as a result

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IT WAS in 1896 that Charles Dow, co-founder of Dow Jones & Company, created the index that still bears his name. Today, indices such as the Dow Jones Industrial Average and the S&P 500 (for shares listed in New York), or the FTSE 100 (for London), are among the best-known brands in financial markets. The role they play has expanded massively in recent years. Index-makers have become finance’s new kingmakers: arbiters of how investors should allocate their money.

 

Stockmarket indices were devised as a measure of the overall market, against which those trading in shares could compare their performance. At first they were concocted by the press or by exchanges themselves. For bonds, indices were compiled by the banks that traded them.

 

Except for a few of the very earliest indices, such as the Dow, which is weighted by share price, nearly all are weighted by market capitalisation or, in the case of bond indices, by the volume of debt outstanding.

 

Three large firms—FTSE Russell, MSCI and S&P Dow Jones Indices—dominate equity index-making. The amounts of money they influence are staggering. S&P Dow Jones reckons $4.2trn in assets are invested in “passive” funds that track its indices, with $3trn assigned just to the S&P 500. Another $7.5trn in actively managed assets use its indices as “benchmarks”: that is, they measure their performance against them. The two other big index-providers command similarly vast sums: $15trn in active and passive money follows FTSE Russell’s indices, and $11trn hug MSCI’s.

 

Index-makers insist they are less powerful than they look. Alex Matturri, head of S&P Dow Jones, points out that even though assets in exchange-traded funds (ETFs), virtually all of which are passive, have reached $4trn globally, that is only a “small part of the global investable universe” (estimated at around $300trn). Mr Matturri also emphasises the transparency and “rules-driven approach” of index construction and governance. Big changes are made only after consulting the market.

 

Moreover, argues Mark Makepeace, chief executive of FTSE Russell, index-making remains very competitive. Some smaller providers, such as Morningstar, give away data on most of their indices (on the weightings of their components, for example). They charge a fee only if a passive fund wants to track an index and use their brand. The big three charge both for access to data and for the use of their indices in passive funds.

 

Regulation also constrains the firms. From January 2018 index-makers in Europe will be directly regulated under the EU’s “Benchmarks Regulation”, which includes requirements such as an annual external audit for benchmarks deemed “critical”, and direct oversight by the EU regulator.

 

Nevertheless, index-makers’ power is considerable. It is boosted by the rise of passive investing.

 

In America, for instance, three-tenths of assets are now in passive funds. And though some smaller competitors survive, the index industry is becoming more concentrated. Many banks have quit the bond-index business, selling their brands. Bloomberg acquired Barclays’ indices last year; FTSE Russell has nearly completed the purchase of Citigroup’s.

 

Despite harping on the objectivity and transparency of their rules, moreover, many of the decisions that index providers make are, ultimately, subjective. Take the decision in June by MSCI to include Chinese shares in its emerging-markets equity index (followed by around $1.6trn in assets). Shares listed in mainland China had been excluded because of the opacity of China’s capital markets, and the restrictions foreigners face there. China’s capital controls remain in place, but, after consulting market participants, MSCI decided to include the shares—albeit at a weighting of only 0.73% (and even that in two phases) so as not to disrupt the index’s composition too quickly.

 

Snap slapped

 

Similarly, both FTSE Russell and S&P, in the wake of Snap’s listing on the New York Stock Exchange in March, chose to alter their rules to exclude companies that list only non-voting shares (as the tech firm did). This stemmed partly from pressure from investors such as Norway’s sovereign-wealth fund. FTSE Russell said that the majority of asset managers it consulted wanted a company’s shares to be included in an index only if the voting power of stockmarket investors passed a threshold of 25%, but the index-maker opted for a lower minimum of 5% and a gradual phase-in, again to avoid disruption.

 

The composition of bond indices has also come under scrutiny. Earlier this year, J.P. Morgan faced calls to exclude Venezuelan bonds from its emerging-market bond index (EMBI) in protest at the misdeeds of the government in Caracas. But index-makers are less mighty in the world of fixed income. Passive investment is less prevalent in bonds than in equities. Moreover, with so many bonds available, fund managers can replicate indices while maintaining some flexibility in the exact choice of assets. A bigger concern with bond indices is their weighting by volume: those who track them end up most exposed to the most indebted borrowers.

 

Index-makers enjoy the prestige that comes from compiling a market’s most recognised benchmark.

 

But they are keener to discuss their work in developing new and different sorts of indices (S&P says it now has over 1m), including for other asset classes. For example, a few indices are starting to provide reliable benchmarks for opaque asset classes like private equity (see box).

 

Other new indices slice up the universe of stocks and bonds in varied ways, such as whether the share prices are undervalued, whether firms are socially responsible or whether they are exposed to specific risks. Kensho, a startup, compiles share indices around trendy themes such as nanotechnology or drones. Some new products bear little resemblance to conventional indice. S&P Dow Jones’s new STRIDE index encompasses different asset classes whose weighting varies over time, to suit the needs of a worker preparing to retire. A few verge on the absurd. This week S&P announced an index containing only companies from which the Indian government wants to divest.

 

For as long as indices have acted as shorthand for the markets they seek to capture, index-makers have received attention. Their importance has grown to match their profile. Being the source of “authoritative guidance” on what should even count as an asset class (as Norway’s sovereign-wealth fund puts it) brings new responsibilities. Index-makers will have to get used to ever more scrutiny.