If Tesla is added to the S&P 500 stock index this year, it will be a great victory for the electric vehicle maker and its shareholders. This is because money managers who manage funds that track the index or compare its performance against it will have to buy Tesla shares. Not Owning the stock (ticker: TSLA), even though it has already shot up 259% this year, earning Tesla a market value of $ 278 billion, could mean that a fund manager’s performance of Big Cap Would Instantly Track The Index, Something Moneyless The manager specializing in the bigger stocks would want to take a chance.
The same concern about underperformance helps explain why much of the stock market rebound in recent years has been fueled by a handful of tech stocks, including Apple (AAPL), Amazon.com (AMZN), and Microsoft (MSFT ), which now dominate the capitalization-weighted S&P 500. Such is the power of indices and index providers such as S&P Dow Jones Indices, majority owned by S&P Global (SPGI). They establish the rules by which companies are admitted to stock indices (rules related to market capitalization, corporate domicile and financial viability, for example), which influences asset flows, demand for individual securities and , in many cases, the composition of our portfolios.
More than $ 8.5 trillion is now held in funds compared to various indices, which account for 41% of the fund industry’s assets, up from 14% in 2005. Stock index funds represent 14% of the stock market. National stocks, down from less than 4% in 2005, according to the Boston Federal Reserve Bank. And more than 18% of global capital is in index-based products, most of them held out of mutual funds and exchange-traded funds, according to BlackRock. Fund managers, consultants and analysts see the percentage of total index funds continue to rise, further cementing the role of index providers in shaping investor preferences and anointing market winners.
Behind this growth is a thriving industry dominated by a handful of giants. S&P Global, MSCI (MSCI) and FTSE Russell, owned by the London Stock Exchange Group (LSE.UK), control 70% of the index market, which totaled $ 3.7 billion in revenue last year, according to Burton-Taylor International Consulting . Other index providers have emerged over the years, including Alerian, Bloomberg, Nasdaq (NDAQ), RAFI, and Qontigo / Stoxx, owned by Deutsche Börse (DB1.Germany), but none have come close to matching the Big Three in income.
“Big index providers are ingrained,” says John White, a former State Street and FTSE Russell executive. “They have the data, the history and the brand recognition, and that’s very useful.”
Index providers generate revenue by licensing indexes to banks, fund companies, and other financial firms for the creation of investment products and internal use. Business is surprisingly lucrative; MSCI reports operating profit margins of 73% in its index business, making it one of the most lucrative areas in financial services. The three leading industry firms also sell other services: S&P operates a bond rating business, MSCI sells analytics services, and the LSE operates securities trading services, among other companies.
The increase in indexation has not only affected individual stocks. Countries and geographic regions can see big entries in the stock market, depending on how they rank in an index. Make MSCI’s decision in 2018 to include Mainland Chinese A shares in its Emerging Markets Index. Adding 472 A-share companies increased China’s total weight from 28% to 41% (in part due to market gains on other China-listed stocks). According to Refinitiv, more than $ 282 billion is indexed or compared to the MSCI Emerging Markets index. MSCI estimated last year that listing A shares in the index could add $ 80 billion in foreign inflows to the Chinese stock market.
However, MSCI was criticized for adding China A shares to its indices. The Wall Street Journal reported in early 2019 that the Chinese government could have pressured the company to list A shares. And Florida Sen. Marco Rubio harshly criticized MSCI last year, writing in a letter to the company that MSCI was providing a legitimacy “imprimatur” to invest in companies controlled by the Chinese Communist Party.
“We don’t bend the rules for anyone,” says MSCI CEO Henry Fernández. “Countries try to explain why they should be better positioned. We say, ‘Here’s the methodology and criteria, and it’s up to you whether you want to attract global investors.’ ”
When asked about the possible influence of the Chinese government on MSCI decision-making, Fernández said that “there was absolutely nothing.”
The influence of indexation has become much more pronounced in recent years, with the increase in exchange-traded funds. Global ETF assets topped $ 6 trillion in 2019, compared to $ 1.3 trillion in 2010. Almost all new ETFs follow an index (apart from some actively managed products). ETF assets are concentrated among three major fund sponsors: Vanguard, BlackRock’s iShares unit (BLK), and State Street Global Advisors, a State Street unit (STT). These companies rely heavily on the MSCI, S&P, and FTSE Russell indices, though Vanguard, looking for lower costs, cut MSCI for some of its international index funds in 2012.
Investment focused on environmental, social and corporate governance, known as ESG, is a particularly fertile area for new indexed products and related services. Institutional investors, such as pension funds and endowment funds, are increasingly evaluating ESG criteria and need reporting in areas such as carbon emissions and labor practices. S&P launched a new ESG assessment service in its ratings division last year and acquired an ESG ratings business in early 2020.
Index providers face a number of headwinds, including stricter regulations in Europe. The European Union issued a comprehensive set of “benchmark regulations” in 2018 to address conflicts of interest in the industry, following a series of scandals in which banks manipulated interest rate indices, such as the interbank interest rate London or Libor. . The new rules aim to avoid tampering with benchmarks and include new governance and reporting procedures.
Index providers are also facing a pullback in rates. BlackRock recently negotiated a new license agreement with MSCI for its iShares ETFs, which could reduce MSCI’s revenue, depending on ETF assets. And new competition is emerging: Some fund companies, especially Fidelity, are building and running their own indexes, with the goal of reducing the cost of licenses. The internal design of the index is one of the reasons why Fidelity could offer zero rate index mutual funds.
But industry experts say it will take much more than the invention of new indices to evict large suppliers. Headlines have too many perks to be displaced, including lots of historical data and trustworthy brands. “Self indexing has always been a fear that has never really materialized,” says BMO Capital Markets analyst Henry Sou Chien.
Fernández doesn’t seem worried either. “It’s more competition, but we welcome it,” he says. “We do not believe it is an existential threat.”
Write to Daren Fonda at [email protected]
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