Active changes to passive indices

0:06Pushkin. Are markets up or down today? Well, everyone figures that out pretty much the same way. You look at an index. Where's the S &P 500? Where is the MSCI world? What's it doing? If you really fancy it, you can look at where the FTSE 100 is trading. These things, everyone knows this, right? Indices are neutral, they're dispassionate, they're objective measures of what markets are doing. Right? Well, you know, not quite. Today on the show, we're here to tell you, indices are not as neutral as you think, and we should probably all think about them a lot more than we currently do. This is Unhedged, the markets and finance podcast from the Financial Times and Pushkin.

0:43I'm markets columnist Katie Martin and to chew through all this, I'm joined by FT contributing editor, Brainbox and fellow pretentious indie music fan, Tobin Angle. How do I respond to that, Katie? I mean, you could respond by telling me what you think the most underrated album of 1996 was. Katie, you're making my life very difficult here. I'm not sure what year Elastica by Elastica came out. I think it might have been 1996. That's a criminally underrated album for my money. Anyway, we're going to bore the youth if we carry on with this. Toby, you used to have a proper job, right? You used to be a fund manager.

1:22Yeah, that's right. Yeah, for 25 years, I was a fixed income, then asset allocation fund manager. Gave it all up a couple of years ago. So when you're doing that job day to day, how important are indices? And also, indices or indexes, which do you prefer? Let's go for indices. Okay. Yeah, the index is pretty important, not because you necessarily want to be an index hugger. When your client gives you, let's say, a billion dollars to try and beat a particular benchmark. Quite a lot of money. Could be quite a lot of money, yep. Then you might have this idea about, here are all the things I really want to buy.

1:55These are fantastic things. But if the things which you're being measured against go in a completely different direction, then you're going to have to have half an eye to that, right? Yeah, yeah. So you'll have a risk department, risk manager saying, you know, you've got this risk budget. How much do you really want to spend on this stuff that you like versus this other stuff about which you have no opinion? Just buy it. So in real life, this person who's given you a billion dollars or like the person in the street who's just like looking at how fund managers perform. Ultimately, they look at the S &P 500 and they say, well, U.S.

2:26stocks have done X. Can you beat that? Can you not beat that? Because if you can't beat that, I can just buy the index for basically free. So it really, you know, it's a really hard yardstick, right? Yeah, yeah, absolutely. I remember actually, I mean, back in the day when I was managing high yield bonds, one of the trickiest, weirdest times was when WorldCom. Do you remember WorldCom? Huge, massive US telecom company starts to go down in flames. But it doesn't go completely down in flames in one go. It goes from investment grade and then it went into the high yield debt universe and at 50 cents in a dollar made up like 10 percent of the market.

3:04Right. And so it becomes hugely binary. And so it comes the question of risk management. Do you buy the stuff that you think is probably going to go bust? Because if it doesn't, then your career's over. Yeah. It's that sort of decision. Yeah. So indices are hugely important for active managers as well as passive people or robots who just have to press the button and buy. Press the button. And so I think there's a kind of general idea out there that indices, they are these neutral benchmarks. But the thing is, there's no such thing, right? Somewhere, a human has to decide what goes into an index and what doesn't.

3:36Like, really, how much discretion is involved here? Yeah, so speaking to different index providers, it varies quite radically. So some are really kind of formulaic. They say, if you do this, then you're in. If you don't do it, then you're out. So if you're a company of a certain size and you've been listed, what, for a certain amount of time? With certain liquidity characteristics and this kind of stuff. And then others, notably the biggest index in the world, S &P 500, they've got an index committee where they've got this big rule book, but then they also, you satisfy those rules and then, well, we'll consider you.

4:10So what are the woolly bits? Tell me about some of the kind of weird stuff that goes on regarding what gets into an index and what doesn't. OK, so should we start with stocks or bonds? I mean, let's start with stocks. because everyone loves stuff. Okay, let's look at the S &P then, right? So you've got to be big, you've got to be liquid. For the S &P 500, you also have to have a certain number of quarters of profitability in order to get in. So they won't put in maybe a meme stock, which has never made an earnings in its life. And so, you know, famously Tesla, right, in 2020, they'd reported earnings and they were positive.

4:45It was a big deal. And so September came and everyone thought, okay, they're going to go into the S &P 500. The index committee met. They looked at it. They should have said no. Stock dropped 21 % on the day. That's amazing. Huge. Roll it forward to November and the index committee go, yeah, OK, they're in this time. So what had changed? How can it be that this committee of wizards kind of get together and say it makes sense now, it didn't make sense a few months ago? I mean, you know, it's a curated index. It's got a little bit more qualitative view. I mean, I guess they probably say, no, it's harder to game the index.

5:24I mean, Robin Wigglesworth wrote this piece on small caps recently. For FT Alphaville. Yeah, for Alphaville. And he was saying that the Russell 2000 has got this sort of gameable aspect, which academics reckon have maybe taken 80 basis points per annum off return. That's 0.8 percentage points for normal people, right? That's right. You can take the man out of fund management, but you can't do the fund management out of the man. But yeah, this has like a really big impact on the bottom line, right? Yeah, yeah, yeah. Huge, huge. Yeah. And so, yeah, when Tesla went in, then all the passive funds had to get ready for December.

6:01So that's the thing. If you've got to match the index, you've got to buy the stuff inside it, right? Yeah, yeah, absolutely. So, yeah, Rob Arnott, who you probably know, chair of research affiliates, a fund management place, he estimated that 78 billion dollars had to go in to tesla in like those few weeks before it was included in the index and on i think the last trading day i think something like a quarter of the market cap changed oh my god the stock rallied 57 yeah period insane yeah absolutely insane so as you say there are some like rules that you just you just have to meet to get into the s &p 500 but But some of these rules are like quite weird, no?

6:43Yeah, yeah. I mean, so, yeah. So the S &P, they've got all these rules. And then there's like four exceptions. There's like spin-outs, acquisitions, migrations, and then Berkshire Hathaway. Berkshire Hathaway just gets in because of Berkshire Hathaway. It's in the rulebook. Yeah, it's in the rulebook, apparently, because they've got multiple share classes. And there's like liquidity issues and all this kind of stuff. They waive all these rights. But it's just under the heading. Berkshire Hathaway is one of their four exceptions. Henceforth, my favourite rule. But so it's not just stocks that are involved here, right?

7:19So you mentioned fixed income, like the entire bond universe is like wrapped up in indices as well. This can be a big opportunity for certain countries that end up getting included. It can be a thorny issue for some investors that don't necessarily want to take risk on those countries. How does that all pan out? A lot of bond investors are measured against things like the Bloomberg Barclays aggregate index and stuff. And so being included or not is going to be a big deal for countries in the capital flows. So China actually getting included in those indices. The IMF did some study. It was going to generate, you know, hundreds of billions of dollars of flows over many, many years.

8:00So that reduced their cost of finance helps fund their capital account or account deficit. Pays the bills. Yeah, pays the bills. And yeah, I mean, there was some interesting stuff that happened on the emerging market debt side. So JP Morgan run the emerging market debt indices that people tend to use. And a few years ago, they introduced, albeit after consultation with investors, a whole variety of countries that had always just been too rich to be emerging. Are you thinking of the UK? No, I mean, so a whole variety of Middle Eastern countries. Right, right, right. They'd always had these index rules, which you need to have a gross national income below a certain amount in order to qualify as being emerging.

8:43And these countries are just way too rich. But they kind of decided that maybe they should be an emerging. They'd issued more debt. And within a year, about a ninth of the index suddenly were these quite low yielding investment grade countries. And so, you know, if I mean, as I said, I used to be an asset allocation person. and we'd look at like what's the characteristic of this market or that market and so you take time series and look back through indices over time but the changing nature of those indices is not something that you'd necessarily dig into all the time to get a view as to what does emerging market do in terms of like correlation with other things right right take it as a unit yeah but there's always stuff happening underneath the surface and that's how you end up with like Saudi Arabia one of the richest countries on the planet being an emerging market bond industry.

9:31Yeah, that's right. Not an emerging market in the way that you or I might think about it. Yeah, yeah. Okay, what does this all mean, right? So you used to be an active manager. You used to use your brain to decide where to put money. There's lots of passive funds out there, and I'm not saying they don't use their brains, but they do just take an index and track the thing, right? And this is growing at a rate of knots. It basically dominates the investment industry now. It's all across equities. It's creeping into fixed income, into the bond world. So I guess it's kind of important that we kind of get this stuff, right?

10:02Yeah, yeah. I mean, I think there's massive scope for the big index funds, be it Vanguard, whoever, to really engage thoroughly with these index providers and do a lot of governance work. It's probably quite expensive to do, to be fair. It sounds fiddly and annoying and all that stuff. Absolutely, yeah. There's also this issue of, like, actually, sometimes the asset managers, they get stuck in, but actually maybe it should be some of the end investors as well. Yeah, yeah. Because, for instance, I understand that one of the reasons why the JP Morgan Emerging Market Index started to consider changing to bring in these Middle Eastern countries is because investors didn't want to lose Poland, Hungary and Czech from the index once they got too rich.

10:46Right, right. But that made me think, is that asset managers that didn't want to lose it? Or is it the end investor? I don't really know. There's this sort of agency problem. Yeah. And these aren't all necessarily bad decisions by any stretch of the imagination. But I guess there just needs to be a better understanding that this is how these things come to life. But so if it was up to you, what would you do? Set up a whole new regulatory body to really annoy people and really kind of stick your nose into this stuff? So the SCT sort of asked the question about what should we do? And loads of people wrote back and said, this is what we should do.

11:20and this is what you should definitely not know because the SEC was wondering, should we regulate them as investment advisors? And then they walked away. Right. They never actually came up with the end result of their consultation. This is far too complicated, wasn't it? So, yeah, I mean, I'd quite like that to finish, really. So if it was me, I'd ask the SEC to finish its investigation. Yeah, finish your job, SEC, says Toby. Okay, so we're agreed. Get on it, regulators. Regulators already exist for this stuff and they need to finish the job. We're going to be back in a minute with Long Short.

12:05Right, now it's time for Long Short. That part of the show where we go long a thing we love, short a thing we hate. Toby, we've not done this before, but what have you got up your sleeve? I've got a long and a short. Well, you've got to choose. Oh, OK. All right. In that case, I'll go short. I'm going to go short the chances that El Salvador stays out of default. Niche. Tell me more. So, again, another Alphabar story, great one on Monday, where Robin covers the country's debt restructuring, where they refinanced expensive debt with much more expensive debt. Cool, cool, cool. Which amortises quite quickly and the coupon jacks up if they don't get an upgrade.

12:43So things are just going from bad to worse for El Salvador. Cool. So I'm going to be long, or at least the market is long. UK stocks. It has finally happened. The C100 has broken through 8 ,000. Like this has been a comically long time coming, a sort of shambolic kind of rally. You know, like when US stocks are on a run, they just sort of run. UK has just been like bumbling along like this for ages. and it's all been a bit of a long, undignified slog. But look, there are plenty of people out there who think, to use the phrase, this time is different. You know, this is not just a blip. This is the start of something big in UK stocks.

13:24So for the sake of patriotism, if absolutely nothing else, I'm going to say long UK. Just as a reminder, this, of course, is not investment advice. All my ideas are terrible. So if you run a fund like Toby used to, then take that under advisement. but Toby it's been very fun to have you here I hope you'll come back Thanks very much, it's been great The Unhedged podcast will be back in a couple of days Unhedged is produced by Jake Harper and edited by Brian Erstad Our executive producer is Jacob Goldstein We had additional help from Topher Forthouse Cheryl Brumley is the FT's Global Head of Audio Special thanks to Laura Clark, Alistair Mackey, Greta Cohen and Natalie Sadler FT Premium subscribers can get the Unhedged newsletter for free A 30-day free trial is available to everyone else.

14:10Just go to ft.com slash unhedged offer. I'm Katie Martin. Thanks for listening.