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The writer is an FT contributing editor
Passive funds are, by construction, price-insensitive bundles of financial securities, weighted to replicate the performance of market indices. But the indices themselves are not entirely passive. And decisions made by index providers are increasingly shaping capital allocation.
By the time Tesla was included in the S&P 500 index, it had already become the sixth-largest US company by market capitalisation. Tesla’s stock had been left out of the S&P 500 despite satisfying each of the published criteria in the index methodology, but the Index Committee had used its discretion not to include it until December 2020.
Rob Arnott — founder of Research Affiliates — estimates that between the committee’s announcement and index rebalance day a month later, index funds needed to buy about $78bn of Tesla stock. A frenzy of activity saw almost a quarter of outstanding Tesla shares trade on the final day of the period, by which time its price had increased by 57 per cent.
The use of discretion by index committees such as S&P Dow Jones’s is rare. Most large providers have an almost algorithmic approach to membership decisions. But the rules themselves are not static.
In 2019 the JPMorgan index committee, following a consultation process, changed rules that had prevented high-income gulf states from having their sovereign bonds included in the EMBI Global range of benchmarks. Debt issued by Saudi Arabia, Qatar, Bahrain, Kuwait and the United Arab Emirates was phased into the index, and by the end of the year constituted almost 12 per cent of the benchmark. These countries’ bonds were transformed into assets that passive funds would be compelled to buy, and on which active managers would need to spend large amounts of portfolio risk to avoid. At around the same time, FTSE Russell changed its recognition of Saudi equities, moving them into the FTSE Global All Cap index — a popular global equity index. Absent these moves it is unclear whether investors would have actively chosen to allocate in size to Middle Eastern sovereigns and companies.
Perhaps most striking have been the series of index changes that have driven capital flows to China in recent years. Between 2018 and 2020, MSCI and FTSE Russell began to include portions of the onshore RMB-denominated A-Share market in their global and emerging market stock indices. Over the same period China’s sovereign debt entered the Bloomberg Barclays Global Aggregate Index, one of the most tracked bond benchmarks. And since 2021 a phased inclusion of Chinese debt into the FTSE Russell World Government Bond Index has been in train.
The IMF estimates that these benchmark changes will have cumulatively driven about $380bn of capital flows into China. They expect that portfolio investments attached to index inclusion are likely to become an important source of financing for Beijing’s current account in the future as its current account surplus turns to deficit.
Index providers are naturally exposed to political scrutiny. Last summer, the House of Representatives Select Committee on the Chinese Communist party launched an investigation into MSCI, arguing that “as a direct result of decisions made by MSCI . . . Americans are now unwittingly funding PRC companies that develop and build weapons for the People’s Liberation Army”. But in the US the providers sit in regulatory limbo.
Gregory Campbell, a financial services assurance partner at PwC, tells me that while EU regulators believe index providers should operate as independent, objective data providers, their US counterparts have questioned whether this is even possible. Given the providers look after index methodologies, they are indirectly responsible for directing investment flows. In 2022 the SEC consulted on whether the providers should be regulated as investment advisers. Since then, they have made no overt move to regulate them.
With the seemingly perpetual growth of passive investing, the importance of index committees grows every day. In the UK, The Investment Association estimates that passive accounts for a third of all assets under management, and index fund assets eclipsed those in actively managed funds in the US market at the end of last year. Decisions as to which securities this money tracks have huge mechanical consequence given their price insensitivity.
The idea of creating a neutral index representing the market is seductively simple. In reality, the challenge of describing and then policing the perimeter of a market is significant. As arbiters of the rule-books defining a market, index committees have become among the most powerful allocators of capital in the world. They deserve scrutiny in accordance with this position.
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