By Chris Matthews
Adriana Robertson, a professor of finance and law at the University of Toronto, has analyzed the methodology of more than 600 equity indices that U.S. funds benchmark themselves to. She found that the vast majority of indexes serve as a benchmark for just one fund, reflecting the fact that index providers often create bespoke indices at the direction of fund companies, which offer products that track these tailor-made compilations of securities.
“They are being created really for the use of the fund,” she said in an interview, adding that this practice of stock selection on the part of index companies should force the SEC to consider them investment advisers and regulate them as such. If the SEC were to enforce the law, she added, index providers that act like investment advisers would need to register with the SEC and assume a fiduciary responsibility to their clients. “Right now this is a completely unregulated relationship,” Robertson said.
Robertson argued that this loophole creates an uneven playing field between active managers who want a relationship with an adviser and index funds that outsource that function to index providers. “Either we think these rules are doing something helpful, or we don’t,” she said. “And if they’re not doing anything, or they’re so burdensome that the costs outweigh the benefits, we shouldn’t subject anyone to them.”
This loophole is not the only way in which financial regulators have encouraged the growth of index investing. Michael Green, portfolio manager and chief strategist at Simplify Asset Management, says that a series of regulatory and legal changes over the decades has been a necessary component in the widespread adoption of index funds by the investing public.
Green points to a 1994 decision by former SEC Chairman Arthur Levitt to not enforce a provision of the 1940 Investment Company Act that would had prevented index fund providers from using derivatives to allow them to better track the performance of indexes. A law passed in 2006 aimed at bolstering Americans retirement savings created incentives for more workers to join 401(k) plans and for employers to choose index funds as the default offering. Today, Green says, nearly 100% of all new 401(k) money entering the market does so through index funds.
“We have a cumulative dynamic where a lot of small policy changes, each one of them seemingly inconsequential, facilitated the growth of passive management to this point,” Green told MarketWatch.
The problem, Green says, is that passive flows of retirement savings into market indexes like the S&P 500 means that billions of dollars every week flow into the market in a manner that is totally indifferent to the fundamentals of the underlying businesses. Because the S&P 500 is weighted by market capitalization, that means savers are not just blindly buying that collection of stocks, but are doing so in proportion to how much money has already flowed into those names, leading to a situation where just five stocks account for a record 23% of the entire market.
These one-way bets increase correlation between stocks on the index and reduce the advantages that can be gained from thoughtful stock picking, creating a snowball effect of ever greater interest in passive vehicles. Green argues that as baby boomers continue to age out of the workforce and stop adding new money to 401(k)s, it could create a liquidity crisis wherein there are few buyers for what new retirees are selling.
“Changes will be made, but it will require a crisis,” Green said. “Increasingly market participants sense that something is off, but to make a significant regulatory change that would change in the investment patterns, the product availability and the fees being charged — it’s really hard to make that change.”
Others argue that while the SEC and other regulators should be watching to understand the systemic implications of these trends, they should also keep in mind the benefits that low-fee index investing have brought the American public.
“Index funds are very inexpensive, and say what you want about the industry, but at the end of the day they deliver access to the most robust growing markets in history,” for miniscule fees, said former SEC Commissioner Jackson “We’ve given access to the market that millions of people wouldn’t have had thirty years ago. That’s an enormous achievement, but what we haven’t done is grapple with the consequences.”