During most of their existence, index providers have operated without direct regulatory oversight.
The regulatory philosophy in the US, relying on the Publisher Exemption for Investment Advisors Act, is to regulate the index product, but not the provider. Courts felt comfortable that index providers were not providing investment advice when creating the index, as the index only reflects the market, was not a recommendation of securities and was offered to a broader audience rather than an investor where there was a direct correlation. This approach has worked well for many years, but is it the case now?
While index providers expanded their business into selling data and analytics systems, for the most part, they stopped offering investment products. For years, the concept of index optimization was an act of differentiation from existing broad-based indices. When the LIBOR scandal broke out in 2012, it disturbed the status quo.
LIBOR changed the index landscape in some very important ways. First, it opened the eyes of regulators to potential conflicts of interest that could exist when the index provider is setting the input price for the index and is issuing or trading products on that index. Regulators found that the ability to influence index levels can have financial implications and, in the absence of proper protection, encourage manipulation of the index. Second, and perhaps most importantly, regulators became aware of the size and breadth of the index provider industry for the first time.
One of the major challenges facing index providers will be the continued increase in regulatory oversight. It was only a matter of time before index providers were directly regulated in the US. The SEC is already looking into the issue. Regulation in the US is inevitable and is being driven by forces outside the control of index providers.
One factor driving further regulation of index providers is the continuous shift from active assets to passive products. While investors and index-focused investment managers such as BlackRock, Vanguard and State Street have benefited from the trend, active managers and stock-picking financial advisors have also seen asset outflows and lower fees. Active managers responded to this trend by consolidating to reduce costs and, more recently, converting their traditional funds to ETFs. These measures do not address the core problem: Studies have shown that proactive managers have a hard time consistently trailing an appropriate benchmark. In addition, as indexed assets have grown, the question of the overall impact of index products on the market is being discussed more frequently.
Another factor accelerating the path of increased regulation is the development of new custom, thematic, strategy and ESG indices. These indices involve more design discretion, and rather than measuring a segment of the market based on capitalization, they are being developed to achieve desired investment results. This focus raises the question of whether index providers are providing any sort of investment advice and are no longer operating under publisher exemptions, which have been used to protect them from direct regulatory oversight.
Finally, with the growth of index-based assets, many are arguing that index managers sponsoring index funds and ETFs have delegated control of governance issues to index providers. This argument arises when index managers claim that they only “follow the index” with respect to security selection. This issue has been exacerbated with the growth of ESG indices and investment products.
With the continued focus on index providers and the development of index-based investment products, increased regulation is inevitable.
One of the issues the SEC is believed to be considering is where to draw the line. Should the regulation cover all indices, including broad-based indices, or only narrow-based indices designed for a single client? In some cases, the European approach is easier to deal with because all index providers are treated equally whereas in the US, we may end up with a regulatory scheme where some indices are regulated and some are not. how they are used. This would mean that some index providers are regulated while others are not resulting in an uneven playing field. Regardless of the regulatory approach, there will be some interesting results.
First, the larger index providers will have an easier time adapting their business. They can bear the cost of being regulated. They have already established the compliance and governance structure that will be required. For a small provider, regulation would increase costs and could be a barrier to entry. For a more complete discussion of the benefits big name providers accrue, and what this could mean going forward, see Part 1 of this series.
Another interesting issue that will arise is liability. Traditionally, index providers avoid liability through disclaimers in their license agreements. In a more regulated environment, one might expect an index method to look like a prospectus with every risk exposed. Changes to the indexing method would require additional public disclosure, such as an amendment to a prospectus. These demands will increase cost and complexity. Under a regulatory scheme, the specter of increased liability in the form of fines, sanctions and civil law lawsuits increase dramatically. Current economics do not provide for this change in legal risk and the possibility of increasing index fees to cover potential liability is a non-starter.
The memory of the LIBOR scandal is still fresh, with regulators around the world looking to prevent future problems. In Europe, BMR has already led the way and is well underway. Other countries including the US will compulsorily follow it.
Alex Maturi is the retired CEO of the S&P Dow Jones Index and is currently an advisor to Index Standard and a member of the Board of Directors of CBOE Global Markets.
