Pension funds have shifted assets worth hundreds of billions from actively managed funds to passive funds in recent years. In doing so, they are part of an ongoing money mass-migration from high-fee active funds to low-fee index funds.

Jan Fichtner, Eelke Heemskerk, Johannes Petry

Jan Fichtner, Eelke Heemskerk, Johannes Petry

Pension funds have shifted assets worth hundreds of billions from actively managed funds to passive funds in recent years. In doing so, they are part of an ongoing money mass-migration from high-fee active funds to low-fee index funds.

In the US, passive funds now have more assets under management than actively managed funds. For pension funds, shifting assets to passive funds is in accordance with the fiduciary duty towards their clients – millions of future pensioners – because the vast majority of active fund managers have not been able to beat benchmark indices over longer time periods.

The rise of passive investing has two important consequences – one well-known and another one that is much less discussed. The first, is the unprecedented concentration of the passive asset management industry in the hands of what we have called the big three: BlackRock, Vanguard and State Street Global Advisors

The second, is that investing in passive funds means delegating investment decisions to those companies that create these indices – usually one of the three main global index providers, whose influence thus has increased greatly. In the words of John Authers, a senior editor at Bloomberg, “indices no longer merely measure markets. They move them”.

In our paper titled ‘Steering capital: the growing private authority of index providers in the age of passive asset management’ we have provided a revealing analysis of the index provider industry, which is dominated by MSCI, S&P Dow Jones Indices and FTSE Russell. Virtually all key benchmark equity indices are created by these three companies. We argue that in the past their indices primarily served informational purposes, serving as benchmarks against which analysts and investors could gauge the performance of portfolios. Indices such as the S&P 500 or the FTSE 100 were first and foremost numerical representations of particular stock markets.

In the past, the decisions of index providers had some impact on investors but overall their role could be characterised as helpful but arguably not essential for investment decisions. This changed fundamentally with the rise of passive investing in the mid-2000s. While the first exchange-traded funds (ETFs) were launched in the early 1990s, investors shunned them for a long time. Only after the global financial crisis did the growth of index funds accelerate rapidly; from 2006 to 2018 about $3.2trn (€2.7trn) have exited actively managed equity funds, while over $3.1trn have flowed into index equity funds. And this trend has continued to 2019 and 2020, despite the COVID-19 market shakeup.

As index providers decide over the composition of key indices they begin to influence capital flows in an immediate way. Whereas in the past indices only loosely anchored fund holdings around a baseline, now they have an instant, ‘mechanic’ effect on the holdings of many passive funds. This is what we call ‘steering’ capital flows. As a result, inclusions of firms or countries into benchmark indices can lead to inflows of many billions of dollars while exclusions can cause large quasi-automatic outflows.

The recent inclusion of domestic Chinese A-shares in the emerging markets indices by MSCI, S&P DJI and FTSE Russell will cause an estimated inflow of $400bn over the next decade. The ensuing strong reactions by US politicians, such as Senator Marco Rubio’s public letter to MSCI, have shown that index decisions have become increasingly politicised, because so much passive assets track them.

But index providers have a steering effect over actively managed funds too. Established indices are increasingly used as direct benchmarks by active funds. This means that not only passive funds shift their investment according to reclassifications by index providers, but also active funds that are benchmarked against these indices. 

Importantly, these decisions over indices are made by a handful of companies as the global index provider industry is highly concentrated. MSCI, FTSE Russell and S&P Dow Jones Indices, hold a combined market share of over 70%. While their revenues are not particularly large, their profit margins stand out as exceptionally high. MSCI reports an operating margin of over 60% for its index segment in 2019. While competition in the index industry is not impossible, our interviewees noted that ‘catching up organically is impossible’ and newcomers could not break the ‘oligopoly of index providers’ as they do not have ‘the brand, the history and the assets attached to that’. This creates a situation where a few index providers make investment decisions for large groups of investors, including many pension funds.

Constructing indices, however, is not a purely technical exercise. While portrayed as objective and rule-based, index providers have significant discretion in devising their methodologies. While many indices are strictly rule-based, some indices – including the S&P 500, the world’s most-tracked index – have committees that make discretionary decisions. In fact, the methodology of the S&P 500 was changed at least eight times between 2015 and 2018, according to research by Adriana Robertson, a professor at the University of Toronto.

A case that highlights this ambiguity in index creation is the fast-track inclusion of the oil giant Saudi Aramco into the emerging markets indices of all three of the main index providers. This means that suddenly millions of pension savers were probably invested in this company without being aware of it. According to the Financial Times, the London Stock Exchange (LSE) even pushed its subsidiary FTSE Russell to scrap its non-renewable energy classification label because it sought to attract Saudi Aramco’s international listing. Similarly, the Wall Street Journal has reported that China’s above-mentioned inclusion resulted from pressures on the index providers by the Chinese government, again calling into question the supposed objectivity of index calculations.

Today, the decisions of the main index providers have a significant impact on global investment flows. In this new age of passive asset management index providers are becoming gatekeepers that in practice exert regulatory power as they steer capital through their index decisions, which are often less objective than they seem. This has important implications for the investment mandate and fiduciary duty of investment funds globally.

Key topics in the next decade will be climate-friendly investing and ESG funds, especially for many pension funds. The three main index providers lead in ESG ratings and therefore decide which firms end up in the portfolios of investors. If standard equity indices necessarily involve a degree of discretion, this is even much more the case for ESG funds. ESG criteria are defined by the index providers, using proprietary methodologies. It makes a huge difference if, for instance, all oil companies are excluded or if only the ‘worst’ oil firms are not part of the portfolio. The new influential role of the three main index providers deserves more scrutiny – especially by pension funds.

Jan Fichtner is senior research fellow and Eelke Heemskerk principal investigator at the CORPNET project, University of Amsterdam. Johannes Petry is ESRC doctoral research fellow at the University of Warwick. Their paper is available at