Benchmarking the World: A Proposal for Regulatory Oversight of Stock Market Index Providers.

Author:McCarthy, Jenna I.

TABLE OF CONTENTS I. INTRODUCTION 1192 II. THE RISE OF PASSIVE INVESTING AND THE IMPORTANCE OF STOCK 1197 MARKET INDICES A. Overview of Active and Passive Management 1197 B. How Is an Index Defined? 1202 III. LEADING INDEX PROVIDERS AND THEIR PROPRIETARY RESEARCH 1208 MODELS A. Dow Jones 1208 B. MSCI Inc 1212 C. FTSE Group 1215 IV. THE RISKS AND OUTCOMES OF INDEX PROVIDERS' CAPITAL ALLOCATION DECISIONS 1218 A. Lack of Transparency for Investors 1218 B. Market Manipulation 1223 C. Changes to Economies for Countries Involved in Capital 1227 Allocation Decisions V. CREATING A REGULATORY FRAMEWORK WITHIN THE UNITED STATES 1233 A. Existing Regulatory Frameworks 1233 B. Proposal for Analogous Regulations in the United States 1235 VI. CONCLUSION 1240 I. INTRODUCTION

When thinking about how to be successful in the stock market, a familiar image often comes to mind: that of the sharp-minded investor who has managed to profit immensely in ways that may seem mysterious and unattainable to the average person. (1) After all, if it were that easy, wouldn't everyone make millions from playing the markets? Perhaps it is unsurprising then that potential investors, whether they are chasing a windfall or simply looking to retire with a comfortable nest egg, often choose "actively managed" funds, or funds that use a manager, or group of managers, in the hopes of beating the market. (2) However, in recent years, Wall Street has witnessed a shift towards a more hands-off, "everyman" approach, known as "passive investing" or "passive management." (3) In contrast to actively managed investments, which involve purchasing individual stocks or bonds, passive investment funds, or "index funds," track stock market indices--such as the Standard & Poor's 500 Index (S&P 500)--with the goal to match the index's returns. (4)

Unlike their actively managed counterparts, passively managed index funds do not use portfolio managers and do not involve any complicated research on the part of an investor; instead, the index fund tracks a stock market index with the intent to match its performance. (5) Since they do not require portfolio managers, index funds often cost much less than actively managed funds. (6) Although there are conflicting opinions, many studies have also suggested that index funds may actually perform better than their actively managed counterparts. (7) Regardless of whether this is true, index funds are highly attractive to investors and continue to rise in popularity. (8)

The rise of passive investments and index funds may seem like a win for investors at first glance. However, increased reliance on passive investments raises questions about regulatory oversight for the underlying stock market indices. Active and passive management strategies are often framed in terms of "beating the market" and "matching the market," respectively. (9) However, how "the market" is defined depends on which index the fund chooses since index funds track individual indices that track different subsets of the market. (10) In contrast to investment funds, which are subject to oversight by regulatory bodies in some capacity, stock market indices are compiled by index providers, which are third parties that use their own proprietary research to produce stock market indices, and are often unregulated. (11) Index providers choose internal committees that determine which companies or countries will make up a stock market index, and the companies that are included in a stock market index may change at any time depending on that committee's decisions. (12) Although this may seem analogous to portfolio managers protecting their investment strategies, portfolio managers are subject to fairly rigorous disclosure requirements due to their involvement with investment managers, which are organizations that make investments in portfolios of securities on behalf of clients in accordance with investment objectives and parameters determined by those clients. (13) This Note argues that this lack of regulatory oversight for index providers is problematic, given their growing role in the overall American economy and potential to affect markets on a global scale.

This Note explores the risks and outcomes related to the current lack of regulatory oversight for market indices and argues that a regulatory framework is necessary to address issues such as investor transparency, market manipulation, and effects on countries' economies resulting from country reclassification decisions. Part II provides a broad overview of stock market indices and differences between active and passive management strategies. Part III compares index methodology for three of the leading index providers: S&P Dow Jones (Dow Jones), MSCI Inc. (MSCI), and FTSE Group (FTSE). (14) Each of these index providers creates their own indices based on independent research and uses proprietary models to classify countries' economies into different categories for inclusion in indices. (15)

Part IV builds on the explanation of each index provider's methodology in order to analyze the benefits and risks of using index providers that engage in independent research to create indices. Part IV begins by discussing the dangers of the lack of transparency for investors that results from a lack of regulatory framework. It then discusses the potential for market manipulation, analogizing to the recent London Interbank Offered Rate (LIBOR) manipulation scandal. LIBOR differs slightly from indices discussed in this Note since it is not a standalone product, but is maintained by banks to serve as a benchmark for their products. (16) However, the LIBOR scandal provides an important case study for market index providers. Part IV concludes by discussing potential effects on countries' economies, both broadly and with respect to Saudi Arabia, which was recently included in emerging market indices. (17)

Part V proposes that index providers' strategies should be subject to greater financial regulation in the United States, which will hopefully lead to greater transparency and uniformity. In doing so, this Note looks to the current regulatory frameworks in place, which include both the European Union's (EU) recent Benchmark Regulation proposal and the 2013 IOSCO Principles for Financial Benchmarks. (18) In lieu of a formal rule or regulation, this Note proposes that index providers register with the U.S. Securities and Exchange Commission (SEC) and engage in formal notice-and-comment periods whenever they add new rules or modify existing rules.


    Annual reports have warned that it is "time to acknowledge the truth" that investors have shifted towards passive management. (19) The Wall Street Journal devoted a series of articles to the "do-nothing" investing revolution. (20) Even a cursory search online reveals headlines with ominous titles suggesting that portfolio managers are doomed to fail in the wake of passive investing's rise. (21) Regardless of what news outlets decide to name it, a change is certainly taking place within the investment industry, with the ongoing debate focusing on the rise of passive management and decline of active management. (22) Investors' shifts towards passive investment and their decisions to invest in passively managed index funds necessarily implicate the role of index providers that determine the composition of market indices. (23) This Part provides an overview of active and passive management. It then discusses the rise of index funds in greater detail and concludes by discussing how an "index" is defined.

    1. Overview of Active and Passive Management

      Roughly 66 percent of mutual fund and exchange-traded fund assets are currently actively managed, according to Morningstar, Inc., a leading investment research firm. (24) While this may seem like a large number, it is down from 84 percent ten years ago, and the number continues to decline. (25) Active management refers to the process of actively buying and selling individual stocks or bonds, either by individual investors or, more commonly, by portfolio managers that work for investment management firms. (26) Investors or portfolio managers seek to "beat the market" through purchasing and selling different combinations of stocks or bonds. (27) Active investing is as old as the stock market itself: as Charles Stein notes, active investing is what used to just be called "investing." (28)

      There are many legitimate reasons why an investor might choose to hire a professional to make investment decisions for them other than the fact that active investment management has traditionally dominated the investment industry. Active management allows for greater flexibility, since a portfolio manager can buy and sell stocks whenever they choose, and strategies can easily be tailored to an investor's desired levels of risk, profitability, and liquidity. (29) In contrast, an index fund requires an investor to purchase all of the underlying stocks on the index. (30) This can lead to problems with liquidity--whether a security is easy to price and can be bought or sold without changing its price significantly. (31) Andy Martin provides a helpful overview of this concept in an article for Advisor Perspectives, warning that the growth of passive investments will lead to lower levels of liquidity in general, not just for individual investors:

      A way to visualize this is by comparing traders for active and passive funds. The active manager, knowing that he wishes to accumulate a stock, checks the price, the high and low for the day, its volume of shares traded, the ex-dividend date, any market news and a variety of other indicators to get a sense of how much market impact his trade could make. He then purchases. In contrast, the index fund or ETF manager has a mandate and must purchase or sell indiscriminately shares in the percentage of their proportion to the underlying index. Though...

To continue reading