Advisers by Another Name

Paul G. Mahoney is David and Mary Harrison Distinguished Professor at the University of Virginia School of Law, and Adriana Z. Robertson is Honourable Justice Frank Iacobucci Chair in Capital Markets Regulation and Associate Professor of Law and Finance at the University of Toronto Faculty of Law. This post is based on their recent paper. Related research from the Program on Corporate Governance includes Index Funds and the Future of Corporate Governance: Theory, Evidence, and Policy by Lucian Bebchuk and Scott Hirst (discussed on the Forum here); The Agency Problems of Institutional Investors by Lucian Bebchuk, Alma Cohen, and Scott Hirst (discussed on the Forum here); The Specter of the Giant Three by Lucian Bebchuk and Scott Hirst (discussed on the Forum here).

The rise of index mutual funds and ETFs is an important development in the U.S. capital markets. Trillions of dollars are invested in vehicles that attempt to track the performance of broad market indices such as the S&P 500 as well as hundreds of lesser-known, specialized indices. While index investing is often described as “passive,” the term is not entirely accurate. Most indices are not purely mechanical. Instead, their construction generally involves the exercise of discretion by an index committee empowered to select among securities meeting the index criteria and to change those criteria over time. Research has shown that in some cases, the discretionary component can be substantial. To a greater or lesser extent, then, an index fund outsources the selection of its portfolio to the index committee responsible for the index it tracks. Because an index fund seeks to mimic the underlying index that it tracks, any inclusion or exclusion decision made at the index level can be expected to feed through to the fund’s portfolio.

Traditionally, the person or entity responsible for selecting a mutual fund’s portfolio was its investment adviser. Investment advisers to mutual funds and EFTs are regulated under the Investment Advisers Act of 1940 (IAA) and the Investment Company Act of 1940 (ICA). These advisers sometimes delegate some or all of their portfolio management duties to sub-advisers, who are themselves treated as investment advisers under both the IAA and the ICA. Yet while an index provider that licenses an index to a fund provides a similar service, to date, the SEC has not taken the position that such an index provider constitutes an investment adviser to that fund. In our paper, Advisers by Another Name, forthcoming in the Harvard Business Law Review, we argue that in some cases, index providers constitute advisers under the IAA and ICA as interpreted by the courts. We further contend that the SEC should clarify when index providers cross the line into investment advice by adopting a safe harbor rule or interpretation.

A handful of well-known indices dominate index investing and related public and academic discourse. These indices, including the S&P 500 and the Russell 2000, generally aim to represent a broad segment of the market (large-capitalization and small-capitalization stocks, respectively). They are often used as benchmarks for active managers, as well as by other market participants for their own purposes. We refer to these as general indices, reflecting their multiple uses and widespread adoption in the market. The thousands of U.S. index funds, however, track hundreds of different indices, many of which are tracked by only a single fund. These specialized indices do not seek to track “the market,” but instead represent a self-selected subset of stocks, often in a particular industry or having particular characteristics that the fund sponsor specifies. We refer to these as single purpose indices. Single purpose indices blur the line between active management and index investing by selecting securities for a particular client to meet that client’s individualized needs. Their providers should generally constitute investment advisers to the relevant funds for IAA and ICA purposes.

The appropriate regulatory treatment of general indices is less obvious. Their proprietors represent themselves as data publishers rather than stock-pickers. That is, they make a list of companies and index weights generally available, and that list is not tailored to the needs of any particular subscriber. The regulatory system doesn’t generally treat this sort of activity as providing investment advice, and both the IAA and ICA exclude publishers from the definition of an “investment adviser.” This argument is valid as far as it goes. However, to receive regulatory treatment as a publisher, an entity must avoid conflicting interests, such as investing or trading in securities on which it reports or receiving compensation from an issuer to report on its securities. It must also refrain from tailoring its reporting to the needs of individual customers.

The line between being a publisher and providing investment advice is accordingly indistinct when it comes to index providers and index funds. To resolve the ambiguity, we propose a safe harbor rule to distinguish between the two activities. This safe harbor proceeds from the Supreme Court’s conclusion that the provision of personalized advice is the hallmark of investment adviser status. To qualify as a publisher, then, an index would have to be non-personalized. Providers of single purpose indices would therefore generally constitute investment advisers. As we discuss in the paper, they are analytically similar to sub-advisers. The SEC treats a sub-adviser as an investment adviser only to the specific fund or portfolio for which it selects stocks. The treatment of special purpose index providers, we argue, should be similar.

In addition to being faithful to the statutory scheme, we believe that our proposed rule would benefit investors. Under our proposal, index providers desiring treatment as publishers would be subject to independence standards designed to ensure that they avoid conflicting interests. Moreover, whether treated as an adviser or publisher, an index provider’s licensing fee would be disclosed in the relevant fund’s prospectus. Under current practice, it may be bundled together with other administrative expenses.

Our proposal would make licensing fees, and therefore the cost of stock selection through an index, more transparent. It would also ensure that an index provider’s discretionary decisions are not the product of conflicting interests. Achieving these goals would not impose a significant burden on index providers. Major index providers, such as S&P Dow Jones Indices, already have in place policies designed to ensure independent decision making in the design and composition of indices.  In addition, general index providers with a global reach are already subject to registration and conflict of interest regulation under EU law.

We also address whether there is a sufficient problem with index providers to justify a regulatory solution. As index investing has grown in popularity, the line between index and actively-managed funds has become blurred. Just as some managers are “closet” indexers, an increasing number of indices are “closet” actively-managed investment strategies. While there is nothing wrong with either practice, the regulatory system has long focused on the substance of an activity rather than the label attached to it. Individuals or firms that provide personalized advice or make non-personalized recommendations that benefit the adviser’s own portfolio or other financial interests constitute advisers under the IAA and ICA, regardless of what they call themselves.

The complete paper is available for download here.

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