Power Brokers of the Investment Markets May Affect Your Investment Returns

When one thinks of the investment markets, it is easy to picture the Chairman of the Federal Reserve as a major force, or maestro as Allan Greenspan was once called, influencing/directing investment flows. Foreign Central Bank reserve managers invest billions and billions, thus swaying markets worldwide. Closer to the average person are investment managers, mutual and exchange traded funds acting as the hand allocating resources. But who influences these players?

With the Maestro types concentrating on the big macro picture, there is a small group of power brokers that are influencing the execution of the investments closer to home. First a little background: there is about $31.38 trillion, as of 2015, of assets in managed mutual funds worldwide. Per Investment Company Institute (ICI), $15.65 trillion is in the US. Add in the rapidly expanding amount invested in Exchange Traded Funds (ETFs), $2 trillion as of 2015, and the numbers are huge.

The reality is that all mutual funds have a benchmark index that they compare their relative performance to. Additionally, they also try to adhere to the risk metrics of these benchmarks. Downward deviations over time from these benchmarks can cause job loss for these managers due to under-performance or style drift. Human nature thus leads managers to build portfolios closer to the indexes they benchmark against.

Now with the rapid rise in popularity of passive investing that seeks to replicate the relevant index as closely as possible, the logical question becomes: “Who controls the indexes and who decides the rules for inclusion in that index?”

Control of these index providers comes down to just four firms: S&P Global (prior to April 2016 McGraw Hill Financial), which owns Standard & Poor’s; Northwestern Mutual, which owns Russell Investments (Russell 1000, Russell 3000, etc.); CME Group, which owns 90% of Dow Jones Indexes; and Bloomberg, which owns the Bloomberg/Barclays suite of indexes that dominate bond indexes. We could even pinpoint the power down further to the divisions/department heads of the respective firms.

There are rules for each of these indexes, but rules can and do change. Also, there is a subjective aspect that is present, too. A great example of this is a recent change in the way Bloomberg /Barclays recently changed methodology. In January, Bloomberg announced changes to its methodology (the minimum amount outstanding for corporate securities in the US aggregate index will be raised to $300 million from $250 million as of April 1, 2017) which would result in the removal of 654 corporate bonds, about $166.7 billion par value, from the high grade US corporate bond index. Some corporate bond issuers will even have all of their indexed bonds become ineligible. Does that mean that the economic condition of these companies has changed? The methodology change will also affect duration in the sub-sectors. Investors that closely follow the index will be forced to sell these companies if they want to limit their tracking error. As one can see, the methodology change may have increased the cost of capital for some firms. Issuers are aware of the power of these indexes and purposely try to structure their bond offerings to fit the rules so that they have an automatic source of demand.

Understanding the structure, rules, and nuances of the index can give the active manager an advantage as securities can become expensive or cheap due to non-economic reasons.

In the end, a benchmark should be the best representation of what the manager is trying to do to serve the needs of the client. It should not be the tail wagging the dog. Capital should flow to firms and sectors based on economic reasons, not because its securities check all the boxes of an index’s rules and subjective conditions.

The views or opinions in this article are those of the author and do not necessarily represent the views of Washington Trust Bank or senior management. Washington Trust Bank believes that the information used in this blog was obtained from reliable sources, but we do not guarantee its accuracy. Neither the information nor any opinions expressed constitutes a solicitation for business or a recommendation of the purchase or sale of securities or commodities.

 

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