Transcript: Active changes to passive indices

This is an audio transcript of the Unhedged podcast episode: ‘Active changes to passive indices’

Katie Martin
The market’s 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.

[MUSIC PLAYING]

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. I’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 Toby Nangle.

Toby Nangle
(Laughter) How do I respond to that, Katie?

Katie Martin
I mean, you could respond by telling me what you think the most underrated album of 1996 was.

Toby Nangle
(Laughter) Katie, you’re making my life very difficult here.

Katie Martin
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 gonna blow the youth if we carry on with this. Toby, you used to have a proper job, right? You used to be a fund manager.

Toby Nangle
Yeah. That’s right. Yeah. For 25 years, I was fixed income, then asset allocation fund manager. Gave it all up a couple of years ago.

Katie Martin
So when you’re doing that job day to day, how important are indices? And also, indices or indexes? Which do you prefer?

Toby Nangle
Oh, let’s go for indices. Yeah. The index is pretty important not because you necessarily wanna be an index hugger. When your client gives you, let’s say, $1bn to try and beat a particular benchmark.

Katie Martin
(Whispering) Quite a lot of money.

Toby Nangle
I know, it can be quite a lot of money, yeah. Then you might have this idea about here all the things I really wanna buy. These are fantastic things. But if the things which you’re being measured against go in a completely different direction, then you’re gonna have to have half an eye to that, right?

Katie Martin
Yeah. Yeah.

Toby Nangle
So you’ll have a risk department, risk manager saying, you know, you’ve got this risk budget, how much do you really wanna spend on this stuff that you like versus this other stuff about which you have no opinion? Just buy it, right?

Katie Martin
So in real life, this person who’s giving you $1bn 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, US stocks 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?

Toby Nangle
Yeah. Yeah, I see. 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 the dollar, made up like 10 per cent of the market. And so it becomes hugely binary. And so in comes the question of risk management. Do you buy the stuff that you think is probably gonna go bust? Because if it doesn’t, then your career is over. It’s that sort of decision. So indices are hugely important for active managers as well as passive people or robots who just have to press the button.

Katie Martin
(Speaking in robotic voice) Press the button. (Speaking normally) 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, because somewhere a human has to decide what goes into an index and what doesn’t. Like really, how much discretion is involved here?

Toby Nangle
Yeah. So speaking to different index providers, it varies quite radically. So some are really quite formulaic. They say if you do this then you’re in; if you don’t do it then you’re out.

Katie Martin
So if you’re a company of a certain size and you’ve been listed, what, for a certain amount of time, I mean . . . 

Toby Nangle
With certain liquidity characteristics and all this kind of stuff. And then others, notably, the biggest index in the world, the S&P 500, they have 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.

Katie Martin
So 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.

Toby Nangle
OK. So, should we start with stocks or bonds?

Katie Martin
I mean, let’s start with stocks. Everyone loves stocks.

Toby Nangle
OK. 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 it in maybe a meme stock, which has never made an earnings in its life. And so, you know, famously, Tesla, right, in 2020, they reported earnings and they were positive. It was a big deal. And so September came and everyone thought, OK, they’re gonna go into the S&P 500. Index committee met. They looked at it. They shook the thing, said no. Stock dropped 21 per cent on the day.

Katie Martin
That’s amazing.

Toby Nangle
Huge. Roll it forward like to November and the index committee go, yeah, OK. They’re in this time.

Katie Martin
But so like what had changed? Like, how can it be that this committee of, you know, wizards kind of get together and say it makes sense now. It didn’t make sense a few months ago.

Toby Nangle
I don’t know, I mean, you know that it’s a curated index. It’s got a little bit more qualitative view. I mean, I guess they probably say, you know, it’s harder to game the index. I mean, Robin Wigglesworth wrote this piece on small caps recently.

Katie Martin
For FT Alphaville, yeah.

Toby Nangle
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 returns.

Katie Martin
That’s 0.8 percentage points for normal people, right?

Toby Nangle
That’s right. Yeah. (Laughter)

Katie Martin
You can take the man out of fund management, but you can’t take fund management out of the man. But yeah, this has like a really big impact on the bottom line, right?

Toby Nangle
Yeah, yeah, yeah. Huge, huge. And so yeah, when Tesla went in then, you know, all the passive funds had to get ready for December.

Katie Martin
So that’s the thing. If you’ve got to match the index, you’ve got to buy the stuff inside it, right?

Toby Nangle
Yeah. Yeah. Absolutely. So yeah, Rob Arnott, who you probably know, he’s chair of Research Affiliates, a fund management place, he estimated that $78bn had to go into Tesla in, like, those few weeks before it was included in an index. And on I think the last trading day, I think something like a quarter of the market cap changed hands. (Laughter)

Katie Martin
Oh my God.

Toby Nangle
The stock rallied 57 per cent in that period. Insane. Absolutely insane.

Katie Martin
So as you say, there are some like rules that you just have to meet to get into the S&P 500. But some of these rules are like quite weird, no?

Toby Nangle
Yeah, yeah. I mean, so yeah. So the S&P, they got all these rules and then there’s like four exceptions. There’s like spinouts, acquisitions, migrations. And then Berkshire Hathaway. (Laughter)

Katie Martin
(Laughter) Berkshire Hathaway just gets in because it’s Berkshire Hathaway.

Toby Nangle
I know. It’s in the rule book. Yeah, it’s in the rule book, 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 of categories.

Katie Martin
Henceforth my favourite rule. But so it’s not just stocks that are involved here, right? So 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?

Toby Nangle
A lot of bond investors are measured against things like the Bloomberg Barclays Aggregate Index kind of stuff. And so being included or not is gonna be a big deal for countries and their capital flows. So China actually getting included in those indices. The IMF did some studies — gonna generate, you know, hundreds of billions of dollars of flows over many, many years. So that reduced their cost of finance, helps fund their capital account or current account, deficit . . . 

Katie Martin
Yep. Pays the bills.

Toby Nangle
Yeah. And yeah, I mean, there was some interesting stuff that happened on the emerging market debt side. So JPMorgan 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.

Katie Martin
(Laughter) You thinking of the UK or . . . ?

Toby Nangle
(Laughter) No. I mean, so a whole variety of Middle Eastern countries.

Katie Martin
Right, right, right.

Toby Nangle
So they’d always had these index rules which, you know, you need to have a gross national income below a certain amount in order to qualify as being emerging. And these countries are just way too rich. But they kind of decided that maybe they should be in 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, you know, what’s the characteristic of this market or of 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, you know, what does emerging market do in terms of like correlation with other things? You just take it as a unit. But there’s always stuff happening underneath the surface.

Katie Martin
And that’s how you end up with, like, Saudi Arabia, one of the richest countries on the planet, being in emerging market bond indices.

Toby Nangle
Yeah, that’s right.

Katie Martin
Not an emerging market in the way that you or I might think about it.

Toby Nangle
Yeah. Yeah.

Katie Martin
OK. 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?

Toby Nangle
Yeah. I mean, I think there’s massive scope for the big index funds, be it Vanguard, whoever, to really, you know, engage thoroughly with these index providers and do a lot of governance work. It’s probably quite expensive to do, to be fair. You probably have to . . . 

Katie Martin
Sounds fiddly and annoying and all that stuff.

Toby Nangle
Absolutely, yeah. It’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 because, for instance, I understand that one of the reasons why the JPMorgan Emerging Market index started to consider changing . . . or to bring in these Middle Eastern countries is because investors didn’t wanna lose Poland, Hungary and Czech from the index once they got too rich. But that made me think, is that asset managers who didn’t lose it or is it the end investor? I don’t really know. There’s this sort of agency problem.

Katie Martin
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?

Toby Nangle
(Laughter) So the SEC sort of asked the question about what should we do? And loads of people wrote back and said, this is what we should do and this is what you should definitely not do, because the SEC was wondering, should we regulate them as investment advisers? And then they walked away. They never actually came up with what the end result of their consultation . . . 

Katie Martin
This is far too complicated.

Toby Nangle
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 and report.

Katie Martin
Yeah, finish the job, SEC, says Toby.

[MUSIC PLAYING]

OK, so we’re agreed. Get on it, regulators. Regulators already exist for this stuff and they need to finish the job. We’re gonna be back in a minute with Long/Short.

[MUSIC PLAYING]

Right. 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?

Toby Nangle
I’ve got a long and a short.

Katie Martin
Well, you’ve got to choose.

Toby Nangle
Oh, OK. All right. In that case, I’ll go short. I’m gonna go short the chances that El Salvador stays out of default.

Katie Martin
(Laughter) Niche. Tell me more.

Toby Nangle
So again, another Alphaville story, great one, on Monday where Robin covers the country’s debt restructuring, where they refinance expensive debt with much more expensive debt.

Katie Martin
Cool.

Toby Nangle
Which amortises quite quickly and the coupon jacks up if they don’t get an upgrade.

Katie Martin
So things have just gone from bad to worse for El Salvador there. Cool. So I’m gonna be long, or at least the market is long, UK stocks. (Makes bugling sound) It has finally happened. The FTSE 100 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 like on a run, they just sort of run? UK, it was 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 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. So for the sake of patriotism, if absolutely nothing else, I’m gonna say long UK. Just as a reminder, this of course is not investment advice.

[MUSIC PLAYING]

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.

Toby Nangle
Thanks very much. It’s been great.

Katie Martin
The Unhedged podcast will be back in a couple of days. Unhedged is produced by Jake Harper and edited by Bryant Urstadt. Our executive producer is Jacob Goldstein. We had additional help from Topher Forhecz. Cheryl Brumley is the FT’s global head of audio. Special thanks to Laura Clarke, Alastair Mackie, Gretta Cohn and Natalie Sadler. FT premium subscribers can get the Unhedged newsletter for free. A 30-day free trial is available to everyone else. Just go to ft.com/unhedgedoffer. I’m Katie Martin. Thanks for listening.

[MUSIC PLAYING]