Stock market indices cannot be obscure

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Among the many changes brought on by the global financial crisis in 2008, one of the most significant was the huge shift from active asset management to passive index funds. The clues that these funds track have in turn gained tremendous power, becoming the gatekeepers to the flow of trillions of dollars.

Names like S&P Dow Jones, FTSE Russell and MSCI are great brands in their own right, generating record revenues by charging fund license fees. The Financial Times itself recently re-entered the index market, thanks to a partnership with Wilshire, 10 years after selling its stake in FTSE on the London Stock Exchange in 2011. Nikkei, which owns the FT, compiles its own index of companies listed on the Tokyo Stock Exchange.

But a scandal that calls into question the integrity of the provider of one of the most commonly tracked indices has disproportionate implications for investors large and small.

A recent discussion paper released by the National Bureau of Economic Research found that companies that purchased credit ratings from S&P Global’s rating activity were statistically more likely to be included in the S&P 500, the index of benchmark for American blue chips managed by another S&P subsidiary.

S&P contends that the document, which has not been peer reviewed, is “flawed” and misleading as to the eligibility rules and methodology of the index. S&P also insists that it has a strict separation of business lines. Granted, some of the newspaper’s claims may seem exaggerated, given that S&P is a major player in both credit rating and index provision. A company can naturally seek a credit rating to help it in its expansion efforts which would propel it into the index anyway.

But accusations of conflicts and pay-to-play in indices are particularly problematic for S&P, whose rating business was marred by similar allegations during the financial crisis, as well as other major rating agencies. S&P paid $ 1.4 billion to settle with the US Department of Justice in 2015 after being accused of inflating the ratings it gave to mortgage derivatives to win business with rivals on approach of the crisis.

Pay-to-gamble claims wouldn’t have any influence if the clues worked in a stereotypical fashion. While it is well known that the S&P 500 is not an index of America’s 500 largest publicly traded stocks – rather, “leading companies in high-tech industries” – the degree of discretion allowed in the process is perhaps the thorniest issue that highlights the document, which now needs to be addressed.

S&P argued that discretion allows it to keep sectors balanced, as well as the element of surprise, which prevents hedge funds from making high profile decisions about new members. S&P also cites the case of AIG, the insurance giant bailed out by the US government in 2008. AIG should then have left the index, but S&P claimed that keeping the insurer’s members avoided further of panic.

S&P allows a more subjective judgment than other indices. The document found that the S&P eligibility criteria alone explained only 62% of the composition of the index between 1980 and 2018, and only 3% of new additions. This leaves a lot of money chasing after a committee’s advice on what constitutes the “right” makeup of its index. Allegations of capture, whether by industry or politics, are almost inevitable.

Transparency is essential as questions about the composition of indices become more relevant. This will be especially true in areas of growing importance, such as ESG investing. It may not be possible to remove the element of judgment entirely. If this is the case, it is important that index providers are not transparent in a discretionary manner, but rather discretionary in a transparent manner.


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