The US financial regulator has earmarked the increasingly more powerful index market for closer scrutiny under a consultation launched last week.
In a request for comment, the Securities and Exchange Commission (SEC) notes financial market indexers along with model portfolio operators and “pricing services” may have veered from information provision to offering investment advice.
Typically, information providers face much lighter regulatory compliance duties compare to investment advisers in the US.
Gary Gensler, SEC chair, said in a statement: “In recent decades, the use of information providers has grown, changing the asset management industry.
“The role of these information providers today raises important questions under the securities laws as to when they are providing investment advice rather than merely information. In order to help the Commission determine when—and under what facts and circumstances—these providers are giving investment advice, the Commission seeks information and public comment to help guide our approach.”
According to the consultation document, index providers now wield considerable influence on global investment markets through financial benchmarks now numbering over 3 million.
“Some are broad-based and widely used, while others are more narrowly focused, including specialized indexes that are designed to be tracked by a particular user,” the SEC says. “Specialized indexes can be composed of constituents on the basis of a variety of considerations, including ‘factors’ that may be seen to cause certain types of securities to outperform or underperform the market as a whole. Index providers that offer specialized indexes might allow a user to ‘specify the customization criteria’ on which a provider can create an index; offer ‘flexibility’ with respect to the components of the index; and can be ‘built to the exact specifications of … clients, in any major asset class’.”
Niche benchmarks such as factor or theme-based and bespoke-designed indexes clearly involve more active decision-making by providers but the regulator includes the broad passive-trackers as potential advice-givers.
“Whether or not an index is specialized, the index provider’s inclusion or exclusion of a particular security in an index drives advisers with clients tracking that index to purchase or sell securities in response,” the SEC paper says.
Index providers may also introduce market integrity risks such as front-running trades based on inside knowledge of any looming benchmark changes.
The SEC raises similar concerns about model portfolio providers and pricing services (which often have wide discretion in valuing assets) but the increasingly concentrated and powerful index industry has caused the most alarm.
Last year, for example, the regulator extracted a US$9 million fine from S&P for a faulty widget in one of its volatility indices in the same month as an academic paper called for the sector to be policed under investment advice laws.
The SEC notes the top three index providers – FTSE Russell, MSCI and S&P – collected about two-thirds of the US$5 billion in revenue accrued across the sector during 2021.
And the indexes keep on coming.
Just as the SEC put the industry on notice, MSCI rolled out a new series of factor indices, bundling up esoteric and mainstream equity analysis into four equity market models.
In addition to well-established ‘smart beta’data, the “next generation” MSCI models include three new factors covering sustainability, crowding and machine-learning.
“The new MSCI Equity Factor Models also evaluate pre-merger Special Purpose Acquisition Corporations (SPACs), expanding the investment opportunity set for investors as well as improving the calculation of some existing factors,” the MSCI release says.
Submissions on the SEC request for comment will remain open for a couple of months.