9 May 2023Sowing the right seeds now will reap untold benefits in the future, and partnering with the right brokerage is the critical first stepsimultaneously, has been at the center of index investing. Automation has also permitted the use of massive data sets to develop indices. The sheer volume of data required for even a "simple" broad market index is staggering. The universe often consists of tens of thousands of companies with hundreds of thousands of securities and millions of data points. All of this data requires additional technology infrastructure so it can be stored, retrieved, and most of all, deemed accurate and reliable. Regulation and Compliance: On June 15, 2022, the Securities and Exchange Commission ("SEC") issued a "Request for Comment on Certain Information Providers Acting as Investment Advisers" ­ (the "Request"). The Request addresses three categories of what the SEC refers to as "information providers" ­ one of whom is index providers. The SEC raises a series of concerns with regard to information providers and notes, in particular, that index providers have "significant discretion" in creating and maintaining financial indices, "in some cases without publicly disclosing their index methodologies or rules." The SEC sees this discretion being exercised at index design, reconstitution, rebalancing, and in response to index component corporate events (i.e., mergers, reorganizations, etc.). The SEC believes that this type of discretion "raises potential concerns about investor protection and market risk," citing front-running trades and conflicts of interest.Indeed, there are several instances where it appears index providers may have been influenced by their own financial interests in making particular indexing decisions. Notably, The Wall Street Journal reported that an index provider added Chinese issuers to an emerging markets index after the Chinese government threatened to stop the index sponsor's business in that country. There is also academic research from Australian National University and Columbia University which suggests that one of the industry's well known index providers often exercises discretion with regard to inclusion in its index in a way that encourages firms to buy fee-based services in order to be included or remain in the index. Companies may be strongly incentivized to have their stocks or bonds included in an index because inclusion or weighting in an index may have significant effects on their ability to raise capital as well as the cost of raising that capital. Creating and managing a compliance framework is key to addressing these regulatory issues for index providers. That framework should begin with establishing three lines of defense with specialist and decision-making bodies addressing index construction and maintenance from the first line of management; an oversight and challenge function drawn from the second line of risk and compliance; and a third line made up of internal and external audit functions supported by a set of independent external advisory committees formed of market practitioners with expertise in benchmark methodologies, input data, and the underlying market. That framework should also include appropriate policies and procedures, sound governance, clear roles and responsibilities, and well-written disclosure. Creating and managing a compliance framework is key to addressing these regulatory issues for index providersKevin Gleason
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