A $3.6 Trillion Regulatory Hole Around ETFs Gets SEC Scrutiny

(Bloomberg) -- A regulator’s work is never done -- and when it comes to exchange-traded funds, it seems it’s only just begun.

The U.S. Securities and Exchange Commission, which is working on an ETF-specific oversight regime and considering reviving a proposal to limit the use of derivatives in the funds, is also asking questions about the stock and bond benchmarks that underpin 98 percent of the $3.6 trillion market for exchange-traded products. Currently the firms that create the indexes supporting these funds do so without SEC supervision.

“Everyone is watching intently and we’re trying to be as best prepared as we can be,” said Dave Gedeon, head of research and development at Nasdaq Global Indexes. “One of the things that’s been the hallmark of the industry has been innovation. I would worry that if we went to a new regulatory regime, that essence of the market would be damaged.”

It’s all part of a broader effort by regulators to get their arms around the fast-growing business that’s seen its U.S. assets triple since 2011, yet has spent decades in the shadows of the investment world.

Index Evolution

Designed to help money managers and their investors judge a fund’s performance versus the market, or a subsection of it, indexes began moonlighting as the linchpin of low-cost investing in the 1970s. Back then, early pioneers like Vanguard Group’s Jack Bogle found they could cut costs by firing big-shot traders and achieve market returns by passively tracking one of these gauges instead.

Since then, investors have witnessed an explosion of indexes. There are now more than 3.28 million market benchmarks worldwide, dwarfing the number of global stocks, according to the Index Industry Association. Licensing these gauges to fund issuers and other asset managers helped S&P Global Inc., MSCI Inc. and the London Stock Exchange Group Plc’s FTSE Russell -- three of the largest indexers -- together generate more than $2 billion of revenue last year, according to the companies.

ETFs have added to the craze, with issuers frequently working with indexers to turn complex strategies more commonly used by active managers into benchmarks. Yet, while the issuers and the resulting funds are regulated, those creating the gauges behind them operate unchecked.

“It’s a purely reputational business,” said Rick Redding, the IIA’s chief executive officer. “If you start miscalculating or putting out indexes that are not representative, no one will use them.”

Teaming Up

Switching to another gauge, however, isn’t always easy or practical, as those who would like to replace the disgraced London interbank offered rate have found.

A spokeswoman for MSCI declined to comment, citing company policy on potential regulation. A spokesman for FTSE Russell declined to comment, while media representatives for S&P did not immediately respond to emails requesting comment.

Indexers in the U.S. rely on a regulatory dispensation known as “the publishers’ exemption” to avoid registering as investment advisers, the way issuers must do. This clause excuses those who distribute advice that isn’t tailored to a specific client or portfolio from more onerous rules. But as issuers and indexers increasingly team up to create bespoke benchmarks some new ones threaten this designation, with indexers appearing to be advising issuers.

“Recent developments appear to have moved certain index providers away from what we might think of as publishers,” Dalia Blass, head of the SEC’s investment management division, said in March. The industry should not assume that index providers qualify for the exemption and should revisit fund disclosure to ensure it is describing these indexes and their strategies clearly and transparently, Blass said.

Judith Burns, an SEC spokeswoman, declined to comment.

Growing Impact

The U.S. is not the only regulator taking a hard look at indexing. Within the European Union, all gauges that are tracked by a fund or used by an investor to measure performance, have been overseen by national watchdogs since new rules took effect in January.

While those regulations stemmed from the Libor fixing scandal, their breadth reflects how influential indexers have become. Inclusion in a particular benchmark can send capital flooding into a country or into a company’s stock, and more than $9.9 trillion currently follows or measures itself against the S&P 500 Index alone. Benchmarkers are also dipping a toe into oversight themselves, with some omitting companies with multiple share classes from their most widely used measures because the structure limits voting rights.

That’s raised eyebrows, even among the issuers that rely so heavily on their services, with Barbara Novick, BlackRock Inc.’s vice chairman, writing that “policy makers, not index providers, should set corporate governance standards.”

Should the SEC decide to pursue its inquiries, the agency’s Office of Compliance Inspections and Examinations could question fund advisers about it, according to Barry Pershkow, a partner at the law firm Chapman & Cutler who used to work at the SEC. These interviews could form the basis of an enforcement action if the SEC determined that an indexer was acting as an unregistered adviser for the fund company -- or even the funds.

“The solution for those folks who are finding themselves in a questionable place is to probably think about rearranging the deck chairs a little,” Pershkow said, possibly by looking more closely at customized indexes with exclusive licensing rights. “The last thing indexers will want to do is register as an adviser and become subject to that regulatory regime.”

--With assistance from Carolina Wilson and Ben Bain.

To contact the reporter on this story: Rachel Evans in New York at revans43@bloomberg.net

To contact the editors responsible for this story: Jeremy Herron at jherron8@bloomberg.net, Eric J. Weiner, Andrew Dunn

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