Index providers should face the same regulatory hurdles as investment managers, a new US legal paper argues.
The University of Virginia School of Law (UVS) report says most index providers are de facto ‘investment advisers’ – a term under US law that includes fund managers and multi-manager firms – and should be policed as such.
Currently, index firms, who now hold huge sway over global markets after the swing to passive investing in recent years, remain exempt from investment adviser regulation in the US as merely information ‘publishers’.
But the paper – authored by legal academics Paul Mahoney and Adriana Robertson – says index providers have shifted from offering neutral benchmarks to building a broad range of investable indices based on subjective criteria.
In 2019 passive investments represented the majority of US stock market holdings for the first time. As at the end of that year, US index-based investments hit about US$8.5 trillion, including US$4.4 trillion in exchange-traded funds (ETFs), the analysis says.
“The rise of index funds means that for a multi-trillion-dollar portion of the fund market, the portfolio allocation decisions are made not by the fund’s nominal investment advisor, but rather by an index provider, which is compensated for its efforts through a licensing fee,” the report says. “This is a major development in the fund industry that in many ways parallels the rise of mutual fund sub-advisers [such as multi-managers].”
While any potential rules could carve-out a ‘safe harbour’ for pure publishing services, the UVS paper says most index providers now create products that deviate from simple benchmark-tracking.
“The point is that index providers are engaged in stock selection on behalf of clients, a defining characteristic of investment advice,” the report says. “One hallmark of the regulation of investment advisers is fiduciary duties and the concomitant avoidance or disclosure of conflicting interests.”
Furthermore, the paper notes the emergence of “single purpose” index products that could allow active managers to hide from tougher regulations behind a passive veil.
“These indices blur the distinction between passive management and active stock selection. The provider constructs an index with the objective of outperforming some other, typically broader, index,” the report says.
“… the differences between funds labeled index funds and those labeled actively-managed funds are a matter of degree, not kind, with substantial diversity within each category. Some actively-managed funds are ‘closet indexers,’ while some index funds are closet active managers.”
If adopted, the Mahoney and Robertson proposal would see most index providers subject to scrutiny by the US regulator, the Securities and Exchange Commission (SEC).
Regulation would enable investors to compare the “cost of stock selection” between passive and active funds on an “apples-to-apples” basis, shed light on index security selection processes and require providers to manage conflict of interests.
“It might have been reasonable to leave the matter unresolved when indexing was in its infancy and index funds tracked only well-known general indices,” the paper says. “Those things are no longer true. The SEC should bring clarity to a multi-trillion-dollar segment of the retail investment market.”
Index providers already face some regulation in the European Union, the report says, covering registration and conflict of interest compliance duties.
Last year the number of global investment benchmarks climbed about 3 per cent to reach more than 3 million, according to the Index Industry Association annual survey of the sector.