Stock Market Indices: Inside the Black Box

The news that a whistleblower contacted U.S. regulators last month about alleged manipulation of the Chicago Board Options Exchange Volatility Index, or VIX, highlights near universal reliance on information that stock market indices provide. While the VIX is not itself a stock market index – it is constructed from the implied volatility of S&P 500 index options – the fact that it is designed to track the expected volatility of another index only reinforces the centrality of indices in the modern economy. Other uses of stock market indices abound: Investors rely on them to evaluate the returns on their investment portfolios. Firms use them to assess their own performance. Mutual fund managers’ compensation is often tied to whether they out-perform a given index. In short, stock market indices are responsible for driving trillions of investment dollars.

Yet very little is known about their internal workings. Like credit rating agencies prior to the most recent financial crisis, they are completely unregulated. Major index providers, such as the FTSE, MSCI, and S&P publish detailed documents that set forth the bases on which stocks are included and excluded from the index, the weighting methodology, rules for rebalancing, and information on how decisions relating to the index are made. But both within and across index providers, the disclosures are highly variable, as is the level of transparency of indices generally.

Much of the prior research on indices has focused on the stock price implications of changes in index composition. Several scholars have documented evidence of significant price effects when securities are added to or removed from an index. Generally, when a security is added, its price jumps, resulting in positive abnormal returns. Conversely, when a security is deleted, its price falls, resulting in negative abnormal returns. While these results are robust across a wide array of markets, what is missing from the existing literature is a comprehensive examination of the decision-making processes employed by these indices.

In this time of financial market volatility, we are analyzing 900 indices used as benchmarks for U.S. equity mutual funds. While our work is ongoing, we are identifying a phenomenon which we term “index heterogeneity.” That is, these indices are heterogeneous across a number of metrics, including: how stocks are selected for inclusion or exclusion; the timing of these decisions; the data employed in making these decisions; the weighting of the selected stocks selected for the index; and governance structures within index providers themselves. Most important, there is no consistency in the disclosure provided by stock market indices, let alone in the rules that govern them.

Thus, an overarching characteristic of almost all stock market indices is that decision-making occurs in a “black box,” lacking transparency. If an index mentions its governance at all, it typically provides a vague reference to a committee that oversees the index. Unlike boards of public corporations, whose governance practices are mandated, the committee can be and often is comprised of non-independent persons who are described as having extensive experience in global equity markets. Because indices make decisions that have significant effects on financial markets, we must ask whether regulators should examine their governance and at least set baseline requirements for disclosure.

This issue has become increasingly salient as index providers make decisions that affect the governance of companies seeking to be listed on major exchanges. Following the Snap Inc. IPO, two major index providers, S&P and FTSE, announced changes in their rules regarding firms that issue multiple classes of shares. This is different from the emergence of corporate governance indices (CGIs), which are specific indices that allow or encourage companies to differentiate themselves on the basis of their governance. Major indices are simply telling firms that they will not be included in the indices if they exhibit a certain type of governance. The fact that investors are demanding – and companies seem to be paying attention to – these statements, highlights the increasing power of indices.

The issue is not just whether stock market indices should exercise influence over firm governance but also how the indices make these decisions in the first place. In other words, what are the governance practices of the indices themselves? Given the extent to which the market relies on the information that indices provide, should they be subject to some form of regulatory oversight, including disclosure requirements? These are pressing questions that merit urgent answers.

Anita Anand and Adriana Robertson are professors at the University of Toronto’s Faculty of Law and are cross-appointed to its Rotman School of Management. A version of this article appeared in the Globe and Mail.

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