Index Providers Can Make or Break Passive Investors

Does “building consensus” level the playing field?
This post originally appeared in Money Stuff.

Here are Bloomberg's Tracy Alloway, Dani Burger and Rachel Evans on the power of index providers:

In a market increasingly characterized by passive investing, these players can direct billions of dollars of investment flows by reclassifying a single country or company, effectively redrawing the borders of markets, shaping the norms of what’s considered acceptable in international finance, and occasionally upsetting the travel plans of government ministers. 

"The worry, however, is that passive investing effectively ­passes the proverbial buck," as passive funds don't make active investing decisions about which securities to buy, but instead outsource those decisions to index providers. Of course the index providers pass the buck right back to their clients:

“We’re not activists,” says Mark Makepeace, head of FTSE Russell, which this year banned companies that don’t give shareholders enough voting rights from joining its gauges. “We’re setting the minimum standards that investors generally will accept, and our role is to build consensus amongst that investor community as to what that minimum standard should be.” 

As a social investing process this makes sense. Everyone who wants to invest in, say, emerging markets, gets together and agrees on which countries are emerging markets and how much of each of them they should all buy. (I mean, they don't actually get together and agree, but they effectively do so by communicating with the index providers who are "building consensus.") No one can get an unfair advantage over anyone else by, say, choosing to overweight one market that happens to go up more than the other markets. Everyone agrees on the rules of the game that they are not going to play.

I am being a little sarcastic there, but really it is fine. The basis of passive investing is the belief that you cannot beat the market, and so you resign yourself to getting average performance. Building consensus among all the passive investors, and then all going out and buying the same things, is a good way to implement that belief. You just have to be clear that that is what you are doing. If instead you think that indexes represent some objective truth about the world, that passive investing is just buying "the market" without making any active investing decisions, then the messy reality of index providers will be a bit disappointing.

Elsewhere, here is a story from a couple of weeks ago about an exchange-traded fund with $6 million in assets that used to track an index of Latin American real estate companies but will now track an index of marijuana companies, presumably because not enough people were interested in Latin American real estate. This sort of pivot for an ETF is unusual, but it happens all the time in penny stocks: You start a gold-mining company, raise some money, don't find any gold, pivot to being a medical-marijuana company, raise some more money, don't sell any marijuana, pivot to being a blockchain company, raise some more money, and so on forever. With the rise of passive investing it is only natural that this action will move from companies to ETFs.

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