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Stock market indices cannot be murky

Of the many changes wrought by the global financial crisis in 2008, one of the largest has been the huge shift away from active asset management and towards passive, index-tracking funds. The indices that these funds follow have in turn gained enormous power, becoming gatekeepers to the flow of trillions of dollars.

Names like S&P Dow Jones, FTSE Russell and MSCI are formidable brands in their own right, earning record revenues from charging funds licensing fees. The Financial Times itself has recently re-entered the index business, through a partnership with Wilshire, 10 years after selling its stake in FTSE to the London Stock Exchange in 2011. Nikkei, which owns the FT, compiles its own index of companies listed on the Tokyo Stock Exchange.

But a scandal that questions the integrity of the provider of one of the most commonly followed indices has outsized implications for investors big and small.

A working paper recently published by the National Bureau of Economic Research found that companies that bought credit ratings from S&P Global’s rating business were statistically more likely to be included in the S&P 500, the benchmark index of US blue-chips run by another S&P subsidiary.

S&P argues that the paper, which has not been peer-reviewed, is “flawed” and misleading about the index’s eligibility rules and methodology. S&P also insists that it has a strict separation of business lines. To be sure, some of the paper’s claims may seem overdone, given that S&P is a major player in both the credit rating and index-provision business. A company may naturally seek a credit rating to assist in its expansion efforts that would in any case propel it into the index.

But accusations of conflicts and pay-to-play in indices are particularly problematic for S&P, whose ratings business was tarred with similar allegations during the financial crisis, along with other major credit rating agencies. S&P paid $1.4bn to settle with the US justice department in 2015 after being accused of inflating the ratings it gave mortgage derivatives to win business from rivals in the run-up to the crisis.

Pay-to-play allegations would have no traction if indices operated in a formulaic fashion. While it may be well known that the S&P 500 is not an index of the 500 biggest stocks listed in America — rather, of “leading companies from leading industries” — just how much discretion is allowed in the process is perhaps the most thorny problem that the paper highlights, which now ought to be addressed.

S&P has argued that discretion allows it to retain a balance of sectors, as well as the element of surprise, which impedes hedge funds from front-running decisions around new members. S&P also points to the case of AIG, the insurance behemoth bailed out by the US government in 2008. AIG should have then left the index but S&P has claimed retaining the insurer’s membership headed off more panic.

S&P allows more subjective judgment than other indices. The paper found that S&P eligibility criteria alone only explained 62 per cent of index composition between 1980 and 2018, and just 3 per cent of new additions. That leaves a lot of money chasing a committee’s view of what constitutes the “right” composition of its index. Allegations of capture, either by industry or politics, are almost inevitable.

Transparency is key as questions over the composition of indices become more pertinent. This will be particularly true in areas of growing importance, such as ESG investing. It may be impossible to remove the element of judgment entirely. If that is the case, it is important that index providers are not discretionally transparent, but rather transparently discretional.

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