The FT recently published an article by Robin Wigglesworth titled ‘The Index providers are quietly building up enormous powers’, which covers a number of issues and is well worth reading. It can be summed up in the final two sentences: “Index providers are an under-appreciated power in finance, and that power is only likely to grow. At some point, politicians and regulators will have to stop scrambling after facile headlines, and attempt to tackle this far thornier, more complex issue.”
The obvious response is why? Why did this happen and why should politicians and regulators care?
From our perspective, these are the key questions facing our industry as the shift from active to passive investment intensifies, meaning a growing dependence on passive investments for the achievement of investors’ goals. For most investors these are not esoteric goals, these are very real things, like retirement, building a deposit to buy a house or to pay for children’s education. With this in mind, we believe the index industry is broken, impacting investment outcomes and thereby people’s lives.
Defining investment as ‘passive’ or ‘active’ is not very helpful. Better descriptive terms would be ‘rules-based’ and ‘discretionary’ as they are more informative.. Every passive investment is defined by a set of rules and writing effective and efficient rules takes experience and expertise. The crux of the issue here, is that passive product providers have largely ceded this responsibility to index firms. This is why the power of index providers has grown, which has led to the current and market dynamics that do not always benefit investors. Index providers now own and control the vast bulk of the index IP underpinning the bulk of the assets in passive management. While this may not have been an issue initially, now it is a concern, because ‘economic rent seeking’ level of revenues is becoming common. We see this as further evidence of a growing ‘conflict of interest’, where index providers are putting their own interests ahead of the market. As index IP is concentrated in just a few global index firms, just four firms have a market share of more than 70%/80%, causing market distortions and inefficiencies. For example, there are 14 FTSE 100 (GBP) ETFs listed on the LSE with a combined total of £13.3bn in AUM and they all follow the exact same index rules, so they all do the same thing at the same time. Other market participants know this and take advantage, for example during rebalances. This inefficiency is hard to quantify, but participants believe it can cost between 1 and 2 basis points of lost performance to investors of all sizes and types..
So what is the solution?
Passive asset managers embracing self-indexation is a good start. Taking back control and creating the ability to provide investors with the innovative new products needed to cope with fast evolving world would help. In fact you are seeing more asset managers exploring this option, but they need help. They need an index firm who will help them learn, while also potentially delivering some or all of what is required in the near term. In essence we need to see a transfer of IP expertise, as well as IP, back to asset managers from index firms. We believe that without such a change then we as an industry risk failing our ultimate clients, the investors.
Chief Indexing Officer & Chairman, Moorgate Benchmarks