Should index providers have oversight?

Railway TracksBy construction, both ETFs and passive funds are tracking indices, while active funds are benchmarked against indices. ETFs now represent trillions of dollars. They have a wide diversity and as many reference indices. Passive funds (“index trackers”) also rank in the trillions, albeit on more traditional indices.

As result, index calculators have gained a significant influence on asset allocation. They do investment research. They have discretion in inclusions. They suggest indices and strategies to asset managers. Their decisions move markets. When they fail to calculate correctly, investors lose millions.

Should they be regulated for their de facto role as investment advisors?

The problems

Index providers like S&P Global, MSCI, FTSE Russell, and Bloomberg are currently treated as mere ‘data providers’ by the regulators. Their role is much larger than that. An interesting academic paper by  Adriana Robertson and Paul Mahoney, explains why they are de facto asset managers. Here are some of the arguments:

  • Index licensing fees are based on the value of assets in the tracker fund, like a management fee. With the growth of ETFs, licensing has become a lucrative income stream for calculators.
  • Calculators refuse to disclose their fee structures and bow to the rule of competition.
  • Europe introduced transparency, reliability, and quality standards regulations in 2016, following the Libor Scandal. These rules have become global standards.

Meanwhile,

  • Many of the indices are ‘single purpose’ (unlike the S&P500 or the Russell 200), created on purpose to define a specific fund or investment. That srategy falls inside the ’40 regulations for investment advisers. The exchange should differentiate those indices & roles.
  • There is a potential risk that the selection be made for self-interest. Discretion in index composition notably invites corruption, front-running, insider trading, or pressure by third-parties.
  • Moreover, benchmarks are prone to manipulations (Libor, FX) and have already attracted the attention of the SEC.
  • Some funds abuse the ‘passive’ label in their marketing. They often ask an index provider to build an index based on their proprietary methodology.

The benefits of regulating

The academic article Advisers by Another Name by Adriana Robertson and Paul Mahoney suggests that the SEC specifies what will and will not make the calculators investment advisors, and who needs to be registered. It will specify the fiduciary duty owed to investors, limit the use of performance-based fees, as well as prevent hidden profits. Advisors will have disclosure and contractual obligations, with the responsibility of not respecting guidelines, as well as restrictions on excessive compensations. Fund shareholders may bring actions to recover excessive fees.

The article also provides a long legal analysis as to whether index providers actually match the definition of investment advisors, and if the publisher’s exemption is warranted (single-purpose indices clearly fail that clause).

This approach will help the SEC enforce, as well as give the market clarity and predictability. It will bring transparency and reduce conflicts of interest, while the compliance costs would be modest.

 

Credits

Credits to Adriana Robertson at the University of Toronto and Paul Mahoney at the University of Virginia.

Abstract: The rise of index funds has reshaped the modern American capital markets. Like mutual fund managers, indices now direct trillions of dollars of investor capital. Although it regulates mutual fund managers as investment advisers, the SEC has chosen not to treat the providers of market indices similarly.In this Article, we argue that many index providers are not merely like investment advisers; under the relevant statutory and regulatory regimes, they are investment advisers. The SEC’s failure to recognize this fact reflects an inaccurate and antiquated view of the index fund market.Having established that certain index providers are presently acting as unregulated investment advisers, we propose a regulatory solution. The SEC should create a nonexclusive, conditional safe harbor giving index providers guidance on what activities will and will not make them investment advisers. This would close the regulatory gap in a way that is consistent with the governing statutes and case law without unduly burdening market participants.

Keywords: Index funds, passive investment, mutual funds, Investment Advisers Act, Investment Company Act

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Written by Gontran de Quillacq

Gontran de Quillacq is an expert witness and a legal consultant. He is a recognized authority in options, trading, derivatives, structured products, portfolio management, hedge funds, mathematical finance, quantitative investment, strategy research and financial markets in general.

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