On committee-based index constituent selection and the power of index providers

Blog, News, Opinion

Might some of the concerns surrounding the power of the dominant index providers be resolving themselves?

The September issue of Investment & Pensions Europe (IPE) published a ‘guest viewpoint’ entitled “The growing influence of index providers“, by Jan Fichtner, Eelke Heemskerk and Johannes Petry, based on their full paper “Steering capital: the growing private authority of index providers in the age of passive asset management“. Their work details index providers’ impact on the flow of passive investments, and also on active investments, through the effect of indices used as measurement benchmarks.

Fichter, Heemskerk & Petry argue that “these index providers have become actors that exercise growing private authority as they steer investments through the indices they create and maintain. While technical expertise is a precondition, their brand is the primary source of index provider authority, which is entrenched through network externalities. Rather than a purely technical exercise, constructing indices is inherently political. Which companies or countries are included into an index or excluded (i.e. receive investment in- or outflows) is based on criteria defined by index providers, thereby setting standards for corporate governance and investor access. Hence, in this new age of passive asset management index providers are becoming gatekeepers that exert de facto regulatory power and thus may have important effects on corporate governance and the economic policies of countries.”

Separately, the S&P approach to constituent selection for certain key indices such as the S&P500 has come into the spotlight due to recent alleged actions by one of the S&P selection committee’s members. This approach, of index constituent selection in part by an internal committee rather than primarily according to transparent, publicly-available rules, has been justified in part as a solution to another concern that has resulted from the growing influence of index providers: the problem of the front running of index constituent reviews. This could be through simple fraud via the early release of market-sensitive index constituent changes, as is alleged in the above case, or by simple attention to index rules: all transparent, objective index methodologies can in theory be taken advantage of by simply deriving future index constituent changes by studying those methodologies, and trading ahead of index fund-driven trades.

The wide following of certain indices is therefore giving rise to various concerns, and is starting to drive various calls for actions to resolve those concerns. However, Moorgate Benchmarks would argue that the resolution may already be underway, in the fast-increasing use of disruptor index providers. This is opening the question of the future viability of the current “big index provider” model, and therefore of their future influence, which is under far greater challenge now than at any previous point in time. If this is so, and the use of disruptor index providers and of “custom” or “self-indexed” indices continues to grow, the market may at least in part resolve the issues raised by overly-powerful dominant index providers. We would suggest the following points are particularly relevant.

  • As Fichter, Heemskerk & Petry point out, the brand value of the big index providers has been a major factor in their success. But anecdotal evidence suggests this value is decreasing – more and more providers are dropping the use of index provider brands in their products, and are more willing to switch to alternative indices (whether cheaper, or more appropriate for their needs, or for any other reason) than they have been in the past, and to use their own branding in their product names, rather than that of the index providers.
  • Self indexing / custom indexing allows issuers to provide more specialist products than could be provided merely by following established, big index provider indices. These  products are based on indices they have developed themselves or in conjunction with smaller index providers, indices that match their own beliefs (on ESG or on markets’ economic status, for example), or that reflect their own (sometimes previously active management) expertise, meet a particular niche strategy or theme that they wish to offer, or are in place to ensure the product issuer retains the fiduciary responsibility (and justification for charging for their expertise) that arguably is given over to the index provider when a broadly-used index is tracked.
  • That the use of custom indexes / self-created indexes reduces the likelihood of front running, as the assets tracking those indices will be far lower, as they are provider-specific.
  • The simple existence now of credible alternative index providers, such as Solactive or Moorgate Benchmarks, is likely to reduce the power of the previous dominant players.

It should be noted that switching away from indices that have an existing broad ecosystem of supporting products, derivatives, analysis and so on brings with it some potential downsides – but this has not prevented a very significant and accelerating move towards the use of self-indexing or of indices provided by alternative, lesser-known providers.