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Index funds might sound boring. But who decides which countries and companies to include?

Index providers wield a lot of power in global finance — and that raises big political questions.

- January 8, 2020

Last June, Sen. Marco Rubio accused the American financial firm MSCI of enabling China to gain unprecedented access to U.S. capital, including pension assets managed by the Federal Retirement Thrift. In a letter to the company, Rubio said, “What MSCI is doing is allowing the Chinese Communist Party controlled market, and its state-owned national champion companies, to access a critical source of capital and clothe itself in a facade of legitimacy.”

Whatever one thinks of Rubio’s accusation, it raises a question: How can a relatively unknown company like MSCI shift U.S. investments to China?

Index providers create bundles of different stocks

The answer is that MSCI is an “index provider.” The major global index providers such as MSCI, S&P Dow Jones Indices and FTSE Russell own and construct widely used stock market indexes such as the S&P 500, the FTSE 100 or the MSCI Emerging Markets. A stock index is a weighted (that is: some shares are more important than others) basket of shares of various listed companies.

The S&P 500, for instance, consists of the 500 largest U.S. firms based on their free float market capitalization, which is the value of shares that are freely tradable. Large firms such as Microsoft and Apple are heavily weighted in the index, while Under Armour and TripAdvisor have very small weights. The widely tracked MSCI indexes put together baskets of stocks from different countries, which are classified as “frontier,” “emerging” or “developed” markets. MSCI decides which countries are included and what weight they have in the index.

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Index providers thus determine which companies and countries are included in stock indexes. Some benchmark indexes are strictly rule-based, but many have committees that have discretion to decide on methodological changes. For example, the pivotal S&P 500 index’s committee has decided that member companies of the S&P 500 — the index that like no other epitomizes the American stock market — can be legally domiciled outside the United States in tax havens such as Ireland, Switzerland or Curaçao. In December, Saudi Aramco, the largest global oil company, won fast-track inclusion to key index membership after its IPO. S&P Dow Jones already announced it will make an exception to its foreign availability rule to make sure Saudi Aramco is included.

This is a big business

Historically, stock indexes primarily served informational purposes. In the 1880s, Charles Dow created the first stock index, which consisted of fewer than 20 stocks. Indexes such as the Dow Jones industrial average were printed in newspapers so that investors could gauge the performance of stocks. This remained their primary purpose until the 2008 financial crisis and the rise of passive investment strategies.

In recently published research we show how index providers are being transformed from mere suppliers of information to important actors in global finance that exert private authority and “steer” capital to firms and countries.

Since the global financial crisis, investors have migrated from high-fee actively managed funds to cheap passive funds that simply replicate indexes. In 2007 exchange-traded funds (ETFs), the main kind of index funds, had assets under management of below $1 trillion. Now that has surged to about $6 trillion globally. This burgeoning index funds industry is dominated by the “Big Three” passive asset managers BlackRock, Vanguard and State Street, which have become the largest shareholders of corporate America.

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The move to passive funds has made the major index providers into the new gatekeepers in global finance. Investors in index funds effectively delegate their investment decisions to them. While the number of indexes has exploded in recent years, they are effectively created by three firms that hold a market share of 80 percent in the index provider industry. While everyone invests in ETFs by BlackRock, Vanguard and State Street, it is mainly MSCI, S&P DJI and FTSE Russell that determine which stocks these ETFs buy. As a result, these index providers are in effect “steering” trillions of dollars’ worth of capital by deciding to include or not include particular companies or countries in their indexes.

The three dominant index providers are in a very lucrative position: MSCI, for instance, has extraordinary profit margins of over 70 percent, and revenue has grown from $400 million in 2008 to over $1.4 billion in 2018, primarily because of rising fees asset managers pay to use indexes. That’s why the share price of MSCI has increased twentyfold since November 2008.

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Index providers are political actors

In the past, index providers supplied only information to financial markets. Today, their decisions are highly consequential because they act as de facto global private standard-setters. Their decisions over whether to include or not include firms does not reflect some objective truth or uncontested scientific knowledge. And standard-setting is always political. Indeed, the methodology of the pivotal S&P 500 has been neither neutral nor constant.

The criteria for stock indexes covering “frontier” and “emerging” markets are especially numerous and not precisely defined. This makes the decisions of MSCI, which dominates these multicountry indexes, so political — it essentially controls the definition of who is an “emerging market.” When they included countries such as China and Saudi Arabia, the three large index providers had considerable leeway to interpret the criteria and to decide which weights these countries have in their indexes.

More than $20 billion has flowed into the Saudi stock market because of its recent inclusion in the main indexes. Analysts estimate that capital inflows into the Chinese stock market could be as high as $400 billion over the next decade after its recent inclusion by the three major index providers.

The power of index providers has not gone unnoticed. Politicians and regulators now are beginning to discuss the new power of index providers. Rubio’s letter is a sign of things to come: When three firms determine where U.S. pension funds invest much of their money, political controversy is sure to follow.

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Jan Fichtner is postdoctoral researcher in the CORPNET Project at the University of Amsterdam. Follow him on Twitter @fichtner_jan.

Eelke Heemskerk is associate professor in political science at the University of Amsterdam and heads the CORPNET Project.

Johannes Petry is a PhD candidate in international political economy at the Department of Politics and International Studies, University of Warwick. Follow him on Twitter @johannes_petry.