Index Investing Is Not Just About Being Passive Anymore

Index investing is not just about being passive anymore – it has expanded to meet changing investor needs and demands making index investing more personalized and more customized. Given the changing index investing marketplace, indices and their construction are far more active in leveraging improvements in technology and data. Consequently, index investing and index providers have drawn more scrutiny from regulators. This increased regulatory scrutiny has necessitated the development of more rigorous compliance programs. This article will conclude by describing elements of a compliance program which are reasonably designed to address regulators’ concerns. This article will conclude with describing elements of a compliance program which are reasonably designed to address regulators’ concerns.  

Growth Of Index Investing:

What started as an intriguing idea in the 1960s was finally implemented in the 1970s, when the first index fund was offered to investors. By 2021, passively managed index funds for the first time accounted for a greater share of the U.S. stock market than actively managed funds’ ownership, according to the Investment Company Institute’s 2022 Factbook. Index funds accounted for 16% of the U.S. stock market at the end of 2021, compared with 14% held by active funds. A decade ago, active funds held 20% and index ones, 8%.

Growth of index assets

Assets managed internally, including passive and enhanced strategies, in trillions, as of June 30, 2021.

The surge in indexing investing over the past twenty-five years has fundamentally changed the structure of the investment management industry. Three asset management firms have come to dominate this market – Vanguard, BlackRock, and State Street – using passive index mutual funds, and in particular, exchange traded funds (“ETFs). Index providers, such as MSCI, FTSE, Bloomberg, Dow Jones, and S&P have grown rich from licensing fees related to the use of their indices. As this segment of the market has evolved, the distinction between the asset manager and index provider has blurred as many asset managers have taken index creation and maintenance in-house developing their own proprietary indices. as many asset managers have taken index creation and maintenance in-house developing their own proprietary indices.

The success of index investing has been fueled by several factors: the rapid growth in equity markets, the emphasis on lower asset management fees and costs, the desire for broader diversification, and the need for greater tax efficiency. However, the greatest reasons index investing has become so predominant may indeed be advances in technology, automation, and data.

Technology, Automation And Data:

Standard indices have a single methodology; one ruleset dictating what they own and how they rebalance. The next evolution in index investing has been the advent of custom indices, direct indexing, and self-indexing. With these forms of index investing, the methodology is specialized or personalized by the individual, cause, interest, theme, preference, or a variety of other factors.

Indexing is a great example of a product which sits on what Josh Wolfe, Co-Founder and Managing Partner at Lux Capital, calls a “directional arrow of progress.” In technology, one can observe trend lines, arrows of progress, that show improvement in key product dimensions that matter to customers – often related to cost, speed, convenience, selection, variety, and personalization. Index investing in all of its forms has been able to capture these technology-based advantages and trends.

Technology, including sophisticated algorithms and the computing power needed to continuously analyze and execute trades across hundreds of thousands of portfolios and positions simultaneously, has been at the center of index investing. Automation has also permitted the use of massive data sets to develop indices. The sheer volume of data required for even a “simple” broad market index is staggering. The universe often consists of tens of thousands of companies with hundreds of thousands of securities and millions of data points. All of this data requires additional technology infrastructure so it can be stored, retrieved, and most of all, deemed accurate and reliable.

Regulation And Compliance:

On June 15, 2022, the Securities and Exchange Commission (“SEC”) issued a “Request for Comment on Certain Information Providers Acting as Investment Advisers” – (the “Request”). The Request addresses three categories of what the SEC refers to as “information providers” – one of whom is index providers. The SEC raises a series of concerns with regard to information providers and notes, in particular, that index providers have “significant discretion” in creating and maintaining financial indices, “in some cases without publicly disclosing their index methodologies or rules.” The SEC sees this discretion being exercised at index design, reconstitution, rebalancing, and in response to index component corporate events (i.e., mergers, reorganizations, etc.). The SEC believes that this type of discretion “raises potential concerns about investor protection and market risk,” citing front-running trades and conflicts of interest.

“Index Investing Has Evolved With Technology, Automation, And Data To Become More Personalized And Customized For Investors. However, Regulatory Scrutiny Has Also Increased, Leading To The Development Of More Rigorous Compliance Programs”

Indeed, there are several instances where it appears index providers may have been influenced by their own financial interests in making particular indexing decisions. Notably, The Wall Street Journal reported that an index provider added Chinese issuers to an emerging markets index after the Chinese government threatened to stop the index sponsor’s business in that country. There is also academic research from Australian National University and Columbia University which suggests that one of the industry’s well-known index providers often exercises discretion concerning inclusion in its index in a way that encourages firms to buy fee-based services to be included or remain in the index. Companies may be strongly incentivized to have their stocks or bonds included in an index because inclusion or weighting in an index may have significant effects on their ability to raise capital as well as the cost of raising that capital. with regard to inclusion in its index in a way that encourages firms to buy fee-based services in order to be included or remain in the index. Companies may be strongly incentivized to have their stocks or bonds included in an index because inclusion or weighting in an index may have significant effects on their ability to raise capital as well as the cost of raising that capital.

Creating and managing a compliance framework is key to addressing these regulatory issues for asset managers and index providers. That framework should begin with establishing three lines of defense with specialist and decision-making bodies addressing index construction and maintenance from the first line of management; an oversight and challenge function drawn from the second line of risk and compliance; and a third line made up of internal and external audit functions. These three lines should be supported by a set of independent external advisory committees formed of market practitioners with expertise in benchmark methodologies, input data, and the underlying market. That overall framework should also be complimented with appropriate policies and procedures, sound governance, clear roles and responsibilities, and well-written disclosure. By establishing a compliance program with these elements, asset managers and index providers will be reasonably designing their operation and control environments to meet regulatory requirements