The risks in the power of stock market indices


Stock market indices are a little like the members’ clubs of Mayfair — their rules of admission are strict, numbers are often limited, and companies are desperate to be allowed entry for the status that would confer. They have grown far from their roots as lists of prominent companies on the local exchange; the big ones, like America’s S&P 500, Britain’s FTSE 100 and Germany’s Dax, are global brands in their own right. They have long been used as a way of measuring the performance of the general market and as a proxy for a country’s wider economy. For the investing public, they are often seen as standard bearers of good corporate governance, a sign that a member company has met a strict set of criteria.

Thanks to the relentless rise of passive investing — where funds shun the task of trying to pick winners but invest their money to mimic the composition of an index — they have never been more powerful. There is more than $12tn invested in index funds globally, and trillions more are benchmarked against the major indices, which means that admission into one of these benchmarks has never been more potentially lucrative. One standout example is Tesla’s imminent entry to the S&P 500. The electric carmaker’s value surged this week to more than $500bn as investors bought the shares in anticipation. The net wealth of chief executive Elon Musk has risen along with the stock to more than $100bn.

Yet, like all clubs, the rules that govern the world’s flagship indices have usually included an element of subjective discretion. Nor are they a fail-safe against bad corporate behaviour. Germany’s Deutsche Börse this week announced a major overhaul of the country’s Xetra Dax index, including an expansion from 30 to 40 stocks to reduce the impact of a failing company in the rest of the index. The move follows the collapse of Wirecard, the payments company. The rules of admission are being changed from a focus on market capitalisation and liquidity to include profitability.

The tighter regulations are necessary — and will bring the German index more in line with other benchmarks. Yet the risk of individual companies or a particular sector dominating an entire index is also a challenge for regulators elsewhere. The situation is particularly acute in the US, where Tesla’s inclusion in Wall Street’s most followed index will force tracker funds to sell billions of dollars’ worth of stock in companies that are already constituents and use that money to buy Tesla shares in order to rebalance their holdings.

Moreover, Tesla’s admission will also increase the overall dominance of tech-focused stocks in the index. Analysts at JPMorgan recently pointed out that the combined weighting of technology and communications stocks, as well as Amazon, in the S&P 500 index was 45 per cent. Most of these companies are built on solid ground, with strong balance sheets and business models, but the increased concentration of the index in the hands of just a handful of its largest players brings with it greater risk. If one titan stumbles, it could trigger a wider sell-off.

The economic downturn fuelled by Covid-19 this year has not stopped the advance of index trackers or exchange traded funds. They have continued to advance in line with surging markets, though it remains largely untested whether their popularity will decline if markets fall for a sustained period — potentially magnifying that fall. Retail investors know that where they choose to put their money is at their own risk, whether a company has been included in a benchmark index or not. But the world’s indices should expect greater scrutiny in the future.




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