Introduction and summary
In the world of finance, investors and other market participants use indexes for a variety of purposes. Stock market indexes, such as the S&P 500, constitute a gauge for the overall performance of the stock market. Multiple indexes follow other asset classes such as bonds, commodities derivatives, currencies, and more. Narrow indexes follow smaller segments of the marketplace, such as municipal bonds or biotechnology stocks. And specialized indexes that consider environmental, social, and governance (ESG) factors are becoming increasingly popular for investors.
An increasingly large portion of capital is being allocated according to indexes, often in the form of exchange-traded funds (ETFs). By using these funds, investors have effectively delegated their investment decisions to index providers. These decisions are essentially based on formulas, and the inputs—and even the formulas—vary over time.
This method of investing is less passive than one might expect. Some indexes are created and maintained based primarily on objective criteria, and others rely on significant discretion by index administrators.1 Often, decisions about index construction, including which weights are selected and which particular components are included, are made by committees that retain significant discretion.2 These decisions about what goes into an index or how it is weighted can have large implications for how money flows to companies or even countries. This discretion, coupled by the meaningful economic rewards enjoyed by companies included in popular indexes, create significant risks for investors, including often significant and documented conflicts of interest, such as the possibility of issuers of securities purchasing services from index providers to attempt to influence index membership.3 They might also enable greenwashing, a significant concern for investors attuned to climate risks.
The United States does not currently have a legal or regulatory framework that comprehensively or consistently governs these conflicts and ensures the integrity of the process. This report recommends a series of actions that would enhance the integrity of the indexing process, helping ensure efficient capital allocation and investor protection.
The United States does not currently have a legal or regulatory framework that comprehensively or consistently governs these conflicts and ensures the integrity of the process.
This report also recommends that each financial regulator and supervisor represented at the U.S. Department of the Treasury’s Financial Stability Oversight Council (FSOC) undertake a study of index-based investment products in their respective jurisdictions. The aim of these recommended studies would be to identify regulatory gaps and to inform a regulatory framework for index investing. The report further recommends that each of the federal financial regulators, in coordination with the FSOC, adopt a comprehensive regulatory regime for financial products tied to indexes. That index regulatory regime should be modeled on the principles set forth by the board of the International Organization of Securities Commissions (IOSCO), including establishing minimum expectations for index governance, quality, methodology, and accountability. These principles outline 19 clear expectations designed to ensure the integrity and sustainability of indexes throughout their development, operation, and use. The U.S. Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC) should play leading roles in this exercise, as they oversee both investment funds and derivative products that often rely on indexes.
The rising importance of benchmarks for capital allocation
Some of the most common investment indexes pertain to the stock market. Stock indexes are typically a weighted average of individual market prices, including factors such as market capitalization. Although there are thousands of indexes, only a few are household names.4 Take the case of the S&P 500 Index, which represents a subset of large company stocks in the U.S. market. The same goes for the Dow Jones Industrial Average, an index of just 20 of the largest company stocks. A company’s inclusion in the S&P 500 can increase its share price significantly. For example, Tesla stock increased by more than 60 percent in November 2020 and December 2020 on the expectation that it would be added to the S&P 500 and, with that, billions of dollars of automated investments that had to purchase its shares.5
Other indexes can be useful to gauge the price performance of other segments of the marketplace. For instance, the Russell 3000 comprises the largest 3000 (or so) U.S.-traded stocks,6 while the MSCI Emerging Markets Index tracks large and mid-cap companies across 27 emerging markets, and the S&P 500 Energy Sector Index captures S&P 500 companies that are part of the energy sector.7
These indexes are often turned into investment products that seek to mirror, minus fees, the performance of the indexes themselves. Notably, these index funds often charge management fees to investors that are lower than those of traditional, actively managed mutual funds.8 This cost structure, coupled with historically strong investment performance,9 tax advantages, and the possibility of potentially easy diversification, have prompted investors to allocate more to index funds.10 What started as an intriguing idea in the 1960s was finally implemented in the 1970s, when the first index fund was offered to investors.11 Slowly but surely, index funds have grown to become a massive phenomenon—today comprising a share of the U.S. stock market similar to their actively managed counterparts.12
This growth represented a notable shift from actively managed mutual funds to index funds and, later, also to ETFs. ETFs are a type of security that often tracks an index or an asset and that can be traded in the same way that a stock can.13 Although some ETFs are actively managed, the vast majority of them track a particular index. Investor inflows into ETFs have been large and increasing.14 Equity index funds and, increasingly, equity ETFs have consistently attracted a growing proportion of investments.15
Indexes also play a key role in asset classes beyond equities, including fixed-income securities—such as U.S. treasuries and corporate bonds—commodities, currencies, interest rates, and derivatives.
Indexes play a key role in the functioning of interest rate markets worldwide. In particular, the London Interbank Offered Rate (Libor) has been a widespread reference interest rate since the 1970s. Libor was used extensively as a key input in financial markets and commerce in general. Investigations about fraud and collusion by banks led to several significant financial settlements since 2013 and to the transfer of oversight of the Libor rate and process from the British Bankers Association to U.K. regulators in 2014.16 Since then, regulators have worked to phase out Libor and replace it with other indexes with presumably more governance integrity. In the case of bonds, there are indexes that reflect different segments of the market according to the type of issuer (municipal, corporate, etc.) as well as duration (short-term bonds, medium-term bonds, etc.). Today, there are several significant bond ETFs, including those that cover a broad range of fixed-income assets (for example, the iShares Core U.S. Aggregate Bond ETF), and those that focus on more specific assets, such as investment-grade corporate debt from U.S. issuers (for example, the iShares iBoxx $ Investment Grade Corporate Bond ETF).17 Collectively, index-based, fixed-income funds manage hundreds of billions of dollars—a large and growing portion of all fixed-income investment funds. The inclusion, exclusion, or weighting of debt securities in the index often requires significant judgments by the index provider.18 Furthermore, inclusion in an index may be material to a potential bond issuer, as it may significantly affect the issuer’s cost of capital. Today, corporate debt issuers often structure the terms of their debt securities so as to comply with the various index criteria.19
In recent years, indexes have also been used to underpin investment products seeking to track the prices in everything from gold20 to sovereign currencies to interest rates. For example, foreign exchange indexes measure the price performance of a currency against another currency, or a mix—or basket—of other currencies. For instance, the Bloomberg Dollar Total Return Index tracks the performance of the U.S. dollar against a broad basket of developed and emerging-market currencies based on global trade flows and liquidity measures.
Another phenomenon common for all asset classes has been the proliferation of increasingly narrow indexes that aim to represent economic sectors or investment themes. There are indexes for traditional investment styles such as value and growth stocks and sector indexes or industries. There are also indexes that exclude securities that do not meet certain criteria; for instance, ESG indexes include only securities that comply with certain predefined parameters specified by the index provider.21
Some indexes are designed to track not just whether prices are going up or down, but other characteristics of price dynamics. For example, while the S&P 500 has given rise to four ETFs that directly track the index,22 it is also used as the basis for other products that track some derivative of the index, such as futures,23 through leverage, or by inverting the performance. Similarly, there is an ETF that tracks the price of the VIX Index—a volatility index—but the SEC has also recently approved ETFs that would provide the inverse of the VIX or twice the return of the VIX.24
Furthermore, some indexes are derivatives of other, more common indexes. The Dow Jones U.S. High Momentum Index measures the performance of 200 companies ranked as having the highest momentum, defined as a high 12-month total return. And Standard & Poor is partnering with Twitter to develop an index that would weight S&P 500 component companies according to user sentiment on Twitter.25
The ubiquity of market data and the availability of cheap computing power also allow for the development of increasingly narrow, specialized, and sometimes even customized indexes. Some indexes are created to satisfy investor demand or to follow emerging trends or, arguably, investment fads. There are now indexes that follow stocks involved in blockchain, cannabis, and even “meme stocks”—stocks that have obtained unusual popularity or even cult-like status online.26
Financial companies sometimes create tailored, proprietary indexes in order to offer customized products to clients with idiosyncratic needs. These are often sold to institutional investors such as large pension funds as low-cost, customizable solutions to meet particular investment goals.
An even more customized use of indexes is the recent development of direct indexing. Direct indexing occurs when an investor directly owns the stocks contained in a given index,27 rather than the investor owning an ETF or an index fund in which the investor owns an investment vehicle that in turn owns the stock in the index. With direct indexing, the investor, usually working with an investor adviser, constructs a portfolio of stocks that closely resembles that of a particular index. Direct ownership allows for certain benefits over ownerships through a fund, namely the possibility of voting the shares; the option of engaging in tax-advantageous tactics such as loss-harvesting; the ability to exclude certain stocks that the investor may not favor (perhaps because of ESG considerations); and the option to tweak the portfolio toward certain factors such as growth, among other potential advantages.28 Although this investment strategy is currently only offered to wealthy investors, industry participants anticipate that it will eventually be offered en masse to everyday investors.29 The soundness of direct indexing as an investment strategy relies heavily on the integrity of the indexing process itself.
Lastly, aside from directly controlling the allocation of capital, indexes may also provide a general gauge of market performance for the public at large. For example, indexes are a key reference for the functioning of investment vehicles such as mutual funds. Even though traditional, actively managed mutual funds may not have to follow a particular index, in practice both retail and institutional investors compare a particular fund performance with a particular index. For example, the performance of the Fidelity Magellan Fund is compared with the performance of the S&P 500, and the performance of the Janus Global Life Sciences Fund is compared by Janus with that of both the MSCI World Health Care Index and the S&P 500 Index.30
As a result of this benchmarking, even actively managed products often seek to mimic holdings and weightings reflected by various indexes.31
Considerations for regulators
A large part of the market is allocating capital according to a simple rule: Follow the index. But index funds can be risky, and the SEC has identified several risks for investors in funds tied to indexes.32
Several noteworthy risks associated with index funds give rise to concerns regarding the indexes that undergird them, including index-construction risks, manipulation and self-dealing risks, and distorted capital allocation risks.
Index-construction and tracking risks
A first consideration is what the index is measuring and how accurate it is in doing so. Another consideration is whether an index fund linked to an index actually provides the investor’s desired exposure, even if it is accurately measured.
A threshold question is whether the fund name and its marketing materials accurately reflect what is included in the fund (and index). For example, there are ESG funds that still invest—sometimes significantly—in oil and gas.
Furthermore, if an index seeks to capture the 100-largest U.S. companies, which companies are selected and why might some be included or excluded? How are they weighted? How are those holdings rebalanced? Are investors aware of the impacts of those determinations? Are investors aware of how changes to an index might affect the holdings, risks, and returns of their investments? While these questions may be relatively easily understood for a simple market capitalization-weighted broad index fund, customized, complex indexes—such as customized exchange rate basket products—may give rise to far more complex questions. Notably, the risks associated with indexes may also not be readily apparent to even the most sophisticated investors. For example, in 2012, JPMorgan Chase lost several billion dollars on its investments in a complex debt index—CDX IG-9—that sought to track the default rates of 125 investment-grade issuers.33
There are also particular concerns with whether indexes truly provide exposure in ways that investors seek. For example, the largest holding in the iShares Russell 2000 Value ETF at the end of October 2021 was AMC, which had grown into a particularly speculative asset that had experienced significant valuation changes as a result of its meme stock status. Would value investors appreciate that the largest holding in the index is a stock with a sky-high price/earnings ratio for a company that was starting its own cryptocurrency and nonfungible token sales? Similarly, some investment products that are built on so-called environmental or green criteria may lead to overweighting of fossil fuels. Put simply, what are the holdings and weightings created by an index, and how do those align with expectations of investors or consumers of financial products tied to that index?
There are also questions about how indexes, and the financial products that are structured on top of them, may deviate in performance from what is expected. This difference in performance can be caused by a variety of factors, such as fees, which could produce a drag in performance. Another factor is the so-called tracking error, which is how far the fund’s holdings vary from the index itself.34
Put simply, a fund based on an index may not contain what the investors in the fund think it does.
Manipulation and self-dealing risks
As professor Adriana Robertson has argued, index investing is “a form of delegated management” in which investors delegate investment allocation decisions to index providers.35 While investment decisions are delegated to index providers, the powers, level of latitude, incentives, and conflicts of interest of those providers are not always clear. Unfortunately, in the United States—as opposed to Europe—there is very little regulation to constrain how index providers exercise that power.
In particular, the reasons for the inclusion, exclusion, or weighting of a particular investment, company, industry, or even country by an index are not always transparent. But these decisions carry important consequences. Inclusion of a certain issuer in an index can cause investors to allocate money to that issuer.36 This makes issuers—whether companies or even whole countries—very interested in enhancing the prospect of inclusion in popular indexes.
Not shockingly, there are several instances where it appears index providers may have been influenced by their own financial interests in making particular indexing decisions. Notably, The Wall Street Journal reported that an index provider added Chinese issuers to an emerging markets index after the Chinese government threatened to stop the index sponsor’s business in that country.37 Similarly, will index providers seek to include in popular indexes companies with which they may have significant financial arrangements?
These conflicts of interest are, of course, dependent on the nature and extent of relationships between the index provider and the companies, municipalities, or other issuers of the financial products that are being indexed. Interestingly, many securities exchanges in the United States and abroad have been acquiring and offering an increasing array of data and index products and services. The sales of these products and services may pit the index providers’ overall financial interests against those of investors in those products.
Companies may be strongly incentivized to have their stocks or bonds included in an index because inclusion or weighting in an index may have significant effects on their ability to raise capital and the costs of raising it. What law or rule prevents a company from essentially buying its way into an index? In the United States, there may be none. For example, recent research finds that firms tend to purchase more S&P ratings when there is an opening in index membership, and these purchases appear to improve their chances of entering the index.38 Similarly, as indexes become more customized, potential conflicts of interest can become even more acute. More and more indexes are being developed by a single bank or broker and sold to one or a small handful of investors (or a single fund). Often, the index and the fund are run by the same manager.39
Understanding the potential risks and conflicts of interest in these situations is extremely difficult, as is accurately assessing the products themselves. While customized indexes have led to some disciplinary actions,40 the ability for investors to identify potential abuses is often extremely limited. Therefore, regulators need to step in to protect them.
Distorted capital allocation risks
As index funds proliferate and increase in size, the impacts of index changes are growing as well. These may give rise to risks not only to individual investors, but to broad classes of investors and the economy overall. For instance, if one or two investment committees of large index providers decide to change their views on particular investments—say, risks related to debt securities—they could modify their indexes and quite literally move trillions of dollars in invested capital.
There are many recent examples of reallocations of capital based on decisions of index providers that have resulted in greater risks to investors. One large index provider recently determined to not modify its rules to account for the unprecedented rise in special purpose acquisition companies, thus exposing a broad swath of investors in significant market risks. Similarly, another index provider adjusted one very popular index to include stocks based in China—despite significant, well-documented concerns with the integrity of the financials of Chinese companies—resulting in the shifting of billions of dollars in capital out of other countries and into Chinese issuers.41
But perhaps the biggest question regarding the risks of index-linked investing is based on the role in efficient allocations of capital. Is market capitalization a good metric to determine whether a company deserves more capital? Do index-linked investments reward the best investments, or just those that are already lucky enough to be included? And academic and market observers have even suggested that index-based investment vehicles might affect systemic risks in financial markets. As the CFA Institute explained:
The core issue with ETFs is best explained using an analogy. When the first Standard & Poor’s Depositary Receipt (SPDR) ETF was launched in 1993, index products were envisioned as passengers in a car driven by underlying markets. Because of a multitude of factors, the roles have now reversed in many markets, with ETFs in the driver’s seat and underlying markets relegated to the status of mere passengers. ETFs were admitted into the car as passengers, which means they never had to pass a rigorous driving test. In other words, we do not know how well they drive. Further, given that they now occupy the driver’s seat in many markets as a fait accompli, asking them to stop and take a proper test risks bringing the car to a complete halt. Under such conditions, how do regulators decide which ETFs really know how to drive, and how do we deal with the ones that seem to be dodgy drivers?42
Unique considerations for climate and ESG-related indexes
Many indexes and current and proposed index funds have ESG considerations in their investment mandate, including both broad ESG themes, as well as more specific considerations.43 There are more than 80 ETFs listed in the United States using ESG in the name.44
As of September 2021, assets in U.S. “sustainable” funds totaled more than $325 billion, with 40 percent of those assets coming from passive or index funds.45 Although the matter is not fully settled, there is evidence that ESG considerations are positively correlated with better corporate financial performance.46 Regardless of investment performance, ESG-themed investment vehicles tend to carry higher fees than other investments and seem to be favored by investors, bringing increased revenues to Wall Street.47
Greenwashing, which is a marketing or public relations ploy aimed at representing products or companies as more environmentally sustainable than they truly are, is a major concern for investors and other market participants, as well as regulators.
Not surprisingly, many exchanges, data firms, and banks are aggressively seeking to expand their ESG-related investment offerings, including through providing customized ESG portfolios.48
But what does it mean to be an ESG ETF? In fact, some large ESG ETFs have significant percentages of their net assets in the stocks of fossil fuel companies. 49 Unfortunately, there is no common definition or legal framework for ESG indexes or assets.50 Greenwashing, which is a marketing or public relations ploy aimed at representing products or companies as more environmentally sustainable than they truly are, is a major concern for investors and other market participants, as well as regulators. This definitional risk, coupled with massive inflows into these types of investments, have prompted market observers to wonder about risks in this segment of the marketplace.51
There are, at root, four questions for index providers seeking to make determinations on such ESG-related indexes:
- What information do they collect?
- What is their process for analyzing that information to create the results?
- What is their expertise?
- How are they accountable for accurately collecting, analyzing, and publishing the indexes in ways that are consistent with the objectives?
These questions—and many others—are not likely to be consistently, reliably, or comparably answered without appropriate regulation.
Overview of existing regulations
After it was revealed that the Libor benchmarks used for trillions of dollars in investment products had been manipulated by some of the largest banks in the world, regulators in the United States, Europe, and Asia began a yearslong process to assess and identify the risks associated with those indexes.52 Banking and market regulators around the world ultimately brought billions of dollars in enforcement cases against several of the largest banks, determined to end the so-called Libor indexes,53 and have been working to replace them with less-risky alternatives.54
Interestingly, regulators around the world also began to see similarities in the risks and operations across a broad swath of indexes, ranging from Libor to foreign exchange indexes to the S&P 500 Index to customized notes.
For instance, in September 2012, the International Organization of Securities Commissions, a global group of securities regulators, announced the creation of a task force “to articulate policy guidance and principles for Benchmark-related activities (including those related to effective self-regulation) and consider issues related to transition.”55 In July 2013, IOSCO adopted the Principles for Financial Benchmarks, or the IOSCO principles.56
The regulators outlined 19 principles that sought to address four key sets of questions in benchmark administration across all types of benchmarks: quality of the benchmark, quality of the methodology, governance, and accountability.57
The IOSCO principles seek to focus on the reliability of the data going into the index, how the index is calculated, and to what extent it provides the desired measurement. Furthermore, the principles examine the methodology for establishing and changing the index, as well as the measures, if any, that are taken to ensure that the data are reliable and unmanipulated. Similarly, the IOSCO principles emphasize how an index provider’s governance—including “responsibilities, powers, and conflicts of interest, as well as oversight for third parties”—are also essential for healthy indexes. Lastly, the IOSCO principles seek to promote accountability for all elements of an index, including complaints procedures, auditing, record keeping, cooperation with regulators, and disclosures of deviations and compliance with their disclosed procedures.
In 2016, the European Union adopted the Benchmarks Regulation (BMR), which was intended to implement the IOSCO principles and separate, related efforts by the European Securities and Markets Authority and the European Banking Authority.58 The BMR classifies benchmarks (indexes) into three categories based on the notional size of the financial products that rely upon them: critical benchmark (very large), significant benchmark (large to medium), and nonsignificant benchmark (small). The regulatory burdens associated with each index type vary. Interestingly, many of the largest global index providers have subsequently come into compliance with the various requirements of this regime.
Despite being members of IOSCO, regulators in the United States have not adopted any specialized regulatory framework for indexes or index providers. As in many other contexts, index providers may be held liable for misrepresentations and manipulation, but these broad parameters often provide little guidance for index providers or comfort for investors. Put simply, the optimal amount of regulation in this arena is not zero. Yet, that is essentially where it stands.
Given the unprecedented growth in the number, complexity, and uses of indexes for making capital allocation decisions—as well as the risks to investors, consumers, and markets overall—it is past time for U.S. financial market regulators to adopt a reliable, consistent, and comparable approach to index regulation. Luckily, these regulators likely already have more than adequate authority to do so.
To that end, each of the members of the FSOC should undertake a study of investment products within their respective jurisdictions that rely on indexes to make capital allocation decisions—whether directly or indirectly. The objectives of these studies should be to identify any gaps in authorities between regulators, as well as inform a comprehensive regulatory framework.
As coordinated through the FSOC, each of the federal financial regulators should adopt a comprehensive regulatory regime for financial products tied to indexes. That index regulatory regime should be modeled on the principles set forth by the IOSCO board, including establishing minimum expectations for index governance, quality, methodology, and accountability. Under these four concepts, the IOSCO principles establish 19 clear expectations to help ensure the integrity and sustainability of indexes throughout their development, operation, and use.
Each of the federal financial regulators should adopt a comprehensive regulatory regime for financial products tied to indexes.
The SEC and the CFTC should play leading roles in this exercise, as they oversee both investment funds and derivative products that often rely on indexes. Banking regulators should continue and deepen their engagement not only in Libor transition issues, but on broader governance issues related to indexes.
Indexes play a key and growing role in the functioning of financial markets and commerce in general. Investors, governments, issuers of securities, and financial market intermediaries base many decisions on the fluctuations of indexes. Although some of the process of creating indexes relies on simple, objective parameters, quite a bit of discretion remains. This discretion, coupled with documented conflicts of interest, casts a shadow of doubt over the integrity of indexes. Many investors are becoming increasingly aware of these issues, as their desire to allocate resources to ESG-based investments is somewhat frustrated by the laxity of fund and index nomenclatures and operations in the area. The United States lags behind its peers in recognizing this problem and developing a specialized regulatory framework for indexes and index providers. If U.S. banking and capital markets aim to retain their leading role as trusted markets, it is essential for regulators and supervisors to create the necessary regulatory infrastructure for enhanced trust in indexes.
Tyler Gellasch is the executive director of the Healthy Markets Association, an investor-focused nonprofit coalition educating market participants and promoting data-driven reforms to market structure challenges. His work on this report, however, is strictly in his personal capacity and not as a representative of the coalition.