October 7, 2022.
Producers of financial indices, such as S&P Dow Jones, MSCI, and FTSE Russell, operate under an exemption to the Investment Company Act of 1940 that classifies these players as data publishers. The current dispensations, which were originally meant for newspapers, also extend to index providers. The US authorities were so far of the view that index providers create benchmarks that merely reflect markets and are offered to a broad audience than to specific clients. The regulatory burden has, therefore, been only on index products or funds rather than the index provider.
Change in this view is afoot. Several factors have led to the SEC to review if index providers should be regulated, but the most compelling is the boom in passive index-based investment products and their overall share in the US stock market.
Academic research presents conflicting viewpoints on the impact of the large size of passive index-based investment products leading to market distortions. The paper, titled “How Competitive is the Stock Market? Theory, Evidence from Portfolios and Implications for the Rise of Passive Investing”, found the aggregate stock-level elasticity – how share prices change in response to changes in supply and demand – fell by -35% between 2004 and 2016. On the other hand, the paper titled “What Happened to the Index Effect: A Look at Three Decades of S&P 500® Adds and Drops” shows that the index effect – the excess returns associated with security being added to, or removed from, a headline index – is in a structural decline.
Another aspect the SEC is focused on is the growth of “specialized ESG indices” that are being used in the ever-growing number of investment products. These indices have much more discretion in their design and are being developed to achieve a specific investment outcome.
Thus, the SEC is assessing to bring index providers under its purview by subjecting them to similar rules that set frameworks for any other fund manager. “In recent decades, the use of information providers has grown, changing the asset management industry”, said SEC Chair Gary Gensler. “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”, Gensler added.
Boom in passive investment vehicles in recent years via index funds, ETF, and direct indexing
The share of actively managed funds has historically been higher in the US stock market than that of passive funds, like index funds and ETFs. However, this trend ended with index funds outstripping the latter, holding about $8.5tn in the US stock market value, representing 16% of the total market capitalization of public US companies valued at $53.4tn in 2021 (see figure 1). Actively managed domestic equity mutual funds and ETFs now hold 14%, which is equivalent to $7.5tn in US stocks. Other investors, including hedge funds, pension funds, insurance companies, and individuals maintain the remaining 70%, which corresponds to $37.4tn in total US stock market capitalization, as of December 2021.
Total assets invested in regulated open-end funds in the US were $34.2tn by year-end 2021, of which mutual funds and ETFs accounted for nearly 99%, according to estimates by the Investment Company Institute. The growth of passive funds in this mix has led the SEC to mull changes in rules that would bring index providers in line with the laws that govern the practices of asset portfolio managers. The new regulations would see existing index players competing head-to-head with the established brokerages such as BlackRock, JP Morgan, Goldman Sachs, Fidelity Investments, and BNY Mellon that dominate this market.
Figure 1: Index funds share as % of US stocks capitalization outstrips actively managed funds in 2021
Description: Share of index funds in US stock markets has increased in the last 10 years to finally overtake that of actively managed funds in 2021. Actively managed domestic equity mutual funds now hold 14% of the total value of US stocks, index funds about 16%, with other investors comprising individuals, insurance companies, pension funds and hedge funds holding the remaining 70%. Source: Investment Company Institute Factbook 2022
A new and emerging passive investments approach of direct indexing is witnessing an uptick driven by low costs and a rise in fractional share trading. An investor, through direct indexing, can hold the underlying individual stocks and track the performance of an index instead of buying an ETF or mutual fund. With the investor holding individual shares directly in its account, this practice allows for larger tax benefits and a higher level of personalization. This feature has led to a debate over whether direct indexing is part of active management, as portfolio customization is something that is actively exercised by fund managers. The index regulations could have a spillover effect on direct indexing, which could face partial legal controls, or it may make the entire process more costly as a direct fallout. Added benefits such as lower costs and tax saving opportunities have led the total assets under management (AUM) in direct index funds to increase from ~$100bn in 2015 to about $350bn by 2020 in the US, according to a Deloitte report. In a study published in 2021, Cerulli Associates found that AUM growth in direct indexing could outpace ETF and mutual funds over the next five years (see figure 2).
Figure 2: Projected AUM growth rate by product over the next five years, as of Q1 2021
Description: A study by Cerulli Associates in Q1 2021 expects AUM growth in direct indexing to be 12.4% over the next five years, followed by ETFs with 11.3%, separate managed accounts (SMAs) with 9.6%, and mutual funds with 3.3%. Source: Cerulli Associates
Growth in “specialized ESG indices”
Another reason the SEC has grown wary of the explosive growth of index funds is the newly custom-built, thematic environmental, social, and governance (ESG) indices that are being widely used in several product offerings. The number of indices measuring ESG metrics in 2021 surged by a record 43%, according to a survey by Index Industry Association. The US ESG mutual funds and ETFs increased to a record $400bn in 2021, growing yoy by 32% (see figure 3). The global ESG assets are expected to surpass $41tn in 2022 before crossing the $50tn mark by 2025, which is one-third of the total projected AUM that year, according to a report by Bloomberg Intelligence. Europe dominated this market initially, accounting for one-half of total ESG assets until 2018; however, the US is now in pole position, with about 40% growth in the last two years and total ESG AUM expected to top $20tn by year-end 2022, the report found.
Figure 3: Long-term ESG fund assets grew 32% Y-o-Y to hit record $400bn in 2021
Description: Long-term ESG mutual funds and ETFs rose to a record high of $400bn in 2021. However, the pace of growth was slower compared to the previous two years, it was still up about 32% Y-o-Y. Source: ISS Market Intelligence
Employed methodology under SEC scanner
Critics say that the methodology used in developing these specialized indices involves a higher degree of discretion than regular benchmarks, which has led many to believe that they may produce the desired investment outcome. “Having evolved in size and scope, these indexes are increasingly influential”, said SEC chair Gary Gensler. “Therefore, an index provider’s decision to include particular security in an index often influences users of the index to purchase or sell securities. This raises questions about whether the index provider is providing investment advice”, Gensler continued.
Due to current exemptions, index providers are not required to disclose mechanisms used in designing indices, especially theme-based indices like ESG indices. Moreover, the definitions used to determine the “ESG ratings” have also come under review, as many consider the securities selection criteria to be too vague. MSCI, for example, uses its own metric. With new regulations in place, the commission would likely go after the ideas used in generating those metrics.
The Investment Company Institute (ICI) has classified funds into four categories (broad ESG focus, environmental focus, religious values focus, and Other focus) that use three key approaches for ESG investing: exclusionary, inclusionary, and impact. Using this approach, there were a total of 740 mutual funds and ETFs with assets worth $529bn in 2021 (see figure 4), as opposed to $400bn as illustrated in figure 3, which uses different criterion for ESG classification from ICI. One of the objectives of the SEC is to bring more clarity to the definitions and criterion that set rules for benchmarks and make the employed methodology more transparent for creating indices.
Figure 4: Funds that invest into ESG using ICI criteria were valued at $529bn by year-end 2021
Description: Of the total 740 funds worth $529bn in 2021, 329 funds with assets valued at $210bn fell into the broad ESG focus group, followed by 169 funds with assets of $150bn in the religious values focus group, 134 funds with assets priced at $121bn in the others category, and 108 funds with $48bn worth of assets in the environmental focus group. Source: Investment Company Institute Factbook 2022
Regulations may lead to additional costs
The industry is divided on the benefits of regulations. Detailed disclosures and reporting requirements would increase significantly under the proposed regulation and would result in additional costs that could be passed on to the clients as higher expense ratios. Expense ratio is the percent of investment that fund managers charge their clients annually to manage their asset portfolio. Lower costs of expense ratios make index funds an attractive investment option compared to actively managed funds. The expense ratios of actively managed funds, as well as index funds, have consistently fallen in the last 20 years (see figure 5). This trend could be reversed if SEC’s regulation comes into effect.
Figure 5: Expense ratios of both actively managed and index mutual funds have fallen in last 20 years
Description: The average expense ratio of index equity mutual funds fell from 0.27% to 0.06% during 2000-2021, while the average expense ratio for actively managed equity mutual funds fell from 1.06% to 0.68% during this interval. Source: Investment Company Institute Factbook 2022
Looking to Europe: IOSCO and ESMA rules to set template for SEC regulations?
The rules to govern financial benchmarks already exist with the International Organization of Securities Commissions (IOSCO) having set 38 principles of securities regulation based on three objectives: 1) protecting investors; 2) ensuring that markets are fair, efficient, and transparent and 3) reducing systemic risk. The European Securities and Markets Authority (ESMA) in the aftermath of the LIBOR manipulation scandal also came up with its own Benchmark Regulations (BMR) that could very well serve as a template for the US market regulator.
Major US index providers are already compliant with BMR in the EU, however, integrating those rules with SEC regulations would not be an easy task, given that not all investment products fall under the purview of the US watchdog, whereas ESMA rules are applicable to all index providers and all indices in Europe. For instance, an index based on futures contracts would not be subject to SEC rules, as futures are regulated by the Commodity Futures Trading Commission (CFTC) in the US. However, if the same index is calculated using an ETF as its base, it would fall under the SEC’s jurisdiction. This distinction in product categories could lead to conflicts, where a few US-based index providers could face heavier regulations than others while some may escape legal controls altogether.
Conclusion – Regulations will bring transparency, but implementation remains a challenge
In recent years, calls to regulate the US index providers have been growing, with questions being raised on the types of services they provide as being strikingly like that of fund managers. Paul G. Mahoney and Adriana Robertson in a paper entitled “Advisors by another name” in January 2021 recommended that the SEC should use its rulemaking authority to clarify the status of index providers that provide an equivalent service, citing reasons such as, “When an index fund tracks an index, it is relying on the index provider to select the fund’s portfolio. Providing this form of stock selection would normally trigger regulation under the Investment Advisers Act”.
Tremendous growth in index funds in recent years with their shares surpassing actively managed funds in the US stock market in 2021 has further put the longstanding view of index providers assuming a passive role in question. This could also have an implication on direct indexing, which has constantly been targeted for playing a more active role as it allows for higher portfolio customization and significant tax benefits. In the case of ‘specialized indices’, the regulations would seek more clarity on the definitions used to determine the ESG metrics.
Index providers would likely be asked to make their methodologies public through regulatory filings, which industry watchers believe would lead to additional costs, that would likely be passed on to customers in the form of higher expense ratios.
IOSCO and BMR rules could set a template for SEC regulations, as major US index providers are already compliant with those rules in their respective jurisdictions. However, we see significant challenges in aligning those rules with SEC due to their applicability to distinct financial products.
Investment banks are expected to be affected the most if these regulations are implemented due to the inherent conflicts of interest present at these institutions. Major US-based banks with large trading desks that hold positions in different asset classes whose levels are determined by indices calculated by those banks. We expect to see more US-based investment banks offloading their index administration and calculation activities to third-party suppliers in near future to mitigate regulatory and compliance risks.
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 Investment Company Act of 1940 (govinfo.gov)
 How Competitive is the Stock Market? Theory, Evidence from Portfolios and Implications for the Rise of Passive Investing – April 2021, by Valentin Haddad & Paul Huebner (University of California, Los Angeles) and Erik Loualiche (University of Minnesota)
 What Happened to the Index Effect? A Look at Three Decades of S&P 500 Adds and Drops – September 2021, by Hamish Preston (Director, U.S. Equity Indices, S&P Dow Jones Indices) and Aye Soe (Managing Director, Global Head of Core and Multi-Asset Product Management, S&P Dow Jones Indices)
 Read the complete press release (SEC.gov)
 Total Market Value of U.S. Stock Market (Siblis Research)
 Direct Indexing – A new tool for investors (Evalueserve)
 Next on the horizon: direct indexing (Deloitte.com)
 Direct Indexing Growth Projected to Outpace ETFs, Mutual Funds, and Separate Accounts Over Next Five Years (Cerulli Associates)
 5th Annual Benchmark Survey – Record Growth in Number of ESG Indices, Alongside Broadening of Fixed Income Indices (Index Industry Association)
 ESG May Surpass $41 Trillion Assets in 2022, But Not Without Challenges (Bloomberg Finance LP)
 What Is an Expense Ratio? (The Motley Fool)
 IOSCO Principles for Financial Benchmarks (IOSCO.org)
 ESMA Benchmark Regulations (ESMA)
Advisers by Another Name – January 2021, by Paul G. Mahoney and Adriana Robertson (University of Virginia School of Law)