SEC May Investigate Index Providers

The U.S. Securities and Exchange Commission (SEC) reportedly is preparing to investigate index providers over alleged conflicts of interest. The issue is rising in significance given the explosive growth of passive investment vehicles, most notably index funds, that seek to replicate the performance of various market indexes.

"Fundamentally, millions of American families don't choose what they invest in, an index provider chooses what they invest in," observed Robert Jackson, who was an SEC commissioner from 2018 to 2020, in an interview with MarketWatch. He added: "The choice to include or not include a company in the S&P 500 moves billions of dollars of American families' money in and out of that company. That choice is subject to very little oversight, and it raises potential conflicts of interest that have never been addressed by financial regulators."

SEC Regulatory Agenda Item

In the fall of 2021, the SEC indicated that this was on its rule-making agenda: "The Division is considering recommending that the Commission seek public comment on the role of certain third-party service providers, such as index providers and model providers, and the implications for asset management industry." This entry is in the "prerule stage."

'Not Always Clear How Indexes Are Constructed'

Caroline Crenshaw, a Democratic SEC commissioner, issued this statement to MarketWatch: "Trillions of dollars are tied to the performance of indexes, yet it's not always clear how indexes are constructed or governed. Investors who depend on indexes for their retirement or their children's education deserve to know how their money is being invested and that the investment is in their best interest. The commission should consider ways to ensure these goals."

Alleged Conflicts of Interest

New research suggests that index providers may be tweaking their inclusion criteria to the benefit of issuers with which they have a financial relationship. For example, a recent academic research paper observes that S&P Global Inc. (SPGI) has significant discretion over the companies included in the S&P 500 Index and that "the discretion is often exercised in a way that encourages firms to buy fee-based services from the S&P." 

S&P, meanwhile, vigorously rejects this claim. In a statement to MarketWatch, S&P asserted: "This non-peer-reviewed paper is flawed and contains a number of misleading and inaccurate statements about the S&P 500, its methodology and eligibility rules, and the impact of index inclusion. S&P Dow Jones Indices and S&P Global Ratings are separate businesses with policies and procedures to ensure they are operated independently of one another. Our Index Governance segregates analytical and commercial activities to protect the integrity of our indices."

Stealth Investment Advising

Another study looked at more than 600 equity indexes that are used as benchmarks by U.S. funds. The vast majority were found to be custom-made for just one fund. It is thus arguable that, in these instances, the index creator is acting as an investment advisor and thus should be regulated as one.

Currently, index providers are viewed as data publishers by U.S. regulators, not as investment advisors. As a result, though they have significant and growing influence within the financial markets, they are subject to little regulation.  

However, in 2021, S&P Dow Jones Indices (SPDJI) was fined $9 million by the SEC for failing to disclose a feature of one index that caused a loss of $1.8 billion for Credit Suisse. SPDJI said that it "neither admits nor denies the SEC's allegations."

SEC commissioner Hester Peirce warned that the settlement "may hint at a deeper, unspoken concern that index providers ... are not governed by a regulatory framework explicitly tailored to their activities. I am open to exploring the need for and propriety of such a framework."

The Tesla Case

Athanasios Psarofagis, an ETF analyst at Bloomberg Intelligence, concurs with the view that index providers eventually must face similar regulation to that imposed on investment advisors. "Eventually, that is where this going to go. They have lots of influence and are essentially making key investment decisions—see Tesla's inclusion in the S&P 500," he observed.

When Tesla, Inc. (TSLA) was added to the S&P 500 in December 2020, $83 billion flowed into its shares from index funds and ETFs alone. That was the biggest shift of money as of that point in time from a change in the composition of the S&P 500. When the pending addition of Tesla was announced a month earlier, its share price jumped 13% in a single day.

All this came against a background of skepticism about the long-term sustainability of Tesla's high valuation. Other observers noted that including a stock such as Tesla will increase the overall volatility of the S&P 500, something that most ETF investors may be looking to avoid.

In September 2020, the SPDJI's index committee had decided against including Tesla, even though it met the quantitative requirements. A question for debate is whether this decision should have been given to a committee rather than being governed strictly by a rules-based approach.

Possible Contribution to Systemic Risk

Because many of the most popular equity market indexes, such as the S&P 500, are capitalization-weighted, the majority of new money flowing into passive funds goes into the stocks that already have the largest capitalizations, regardless of business fundamentals. Another concern is that, once aging baby boomers exit the workforce, stop adding to their savings in passive vehicles, and start withdrawing funds, this may spark a liquidity crisis if there is insufficient demand from others to buy what the new retirees are selling.

As of Jan. 31, 2022, the five largest stocks by market capitalization in the S&P 500 represented nearly 21% of the index's value. The top ten represented almost 29%. Tesla was in the top ten, accounting for 1.8% of the value of the S&P 500.