HOLDERS OF LAST RESORT: THE ROLE OF INDEX FUNDS AND

INDEX PROVIDERS IN DIVESTMENT AND CLIMATE CHANGE

PATRICK JAHNKEa

9 March 2019

Abstract: This paper demonstrates that index funds and index providers have
agency and thus responsibility for the companies contained within their financial
products. As a growing number of institutional asset owners are divesting from
coal assets, index funds are becoming the holders of last resort. The common
wisdom has it that index funds cannot sell out of individual stock holdings. They
have a “voice” but no ability to “exit.” This paper investigates the relationship
between index providers and index funds and finds the traditional understanding
that index investors cannot sell to be false. Instead an increasing prevalence of
index investors switching both indices and index providers is noted. Such changes
provide investors with the opportunity to exclude specific stocks. This paper
therefore suggests a number of solutions for index funds to reduce the carbon
intensity of their funds, such as switching the indices their funds employ,
discontinuing niche ETFs that are carbon intensive, reducing fees on low-carbon
investments, or making use of their financial clout as index providers’ biggest
customers to advocate for selective index amendments. Adding the threat of exit
will increase the power of voice. Doing so will ensure, that rather than functioning
as insulators from sustainability pressures, they act as conductors.

Keywords: Index Providers; Index Funds; ETFs; Corporate Governance;

Divestment; Sustainability

JEL classification: A13 Relation of Economics to Social Values, G3 Corporate

Finance and Governance, L2 Firm Objectives, Organization, and Behavior

a
School of Social and Political Sciences, University of Edinburgh, 15a George Square,
Edinburgh, UK. p.d.jahnke@sms.ed.ac.uk.

Electronic copy available at: https://ssrn.com/abstract=3314906

1. Introduction
In January of 2019, a hoax letter demanding companies take a tougher stance on climate
change was posted on the Internet.1 The letter purported to be the annual letter written by
Larry Fink, the CEO of BlackRock, the world’s largest asset manager, to the CEOs of
BlackRock’s portfolio companies. But why did someone go into the trouble of setting up a
website and penning this fake letter?
This event is illustrative of the rising influence ascribed to the asset management
industry. The popularity of index investments, manifested by approximately $3 billion of
inflows per day, is only the most recent stage in the evolution of the fund management industry,
the growth of which started in earnest with the rise of pension fund assets in the early 1980s.
The re-concentration of ownership, which has resulted from institutional investors taking over
from individual shareholders, has significantly increased the influence of shareholders and
turned the large passive investors into the “new power brokers of modern capital markets”
(Fisch, Hamdani and Davidoff Solomon, 2018). Their “hidden power” (Fichtner, Heemskerk
and Garcia-Bernardo, 2017) provides them with the potential to exercise a great deal of
influence over corporate policies and has thus made them institutions of public interest,
attracting significant attention from practitioners and academics alike.
The expanded influence of institutional investors that has resulted from the increase in
ownership concentration raises the question of responsibility. The adoption of the United
Nations 2030 Agenda for Sustainable Development and its seventeen Sustainable Development
Goals (SDGs) in 2015, followed by the Paris Climate Agreement (“COP21”) in 2016, have put
sustainability efforts front and centre of global economic policy debates. Capital markets have
a significant role to play in facilitating this transition to a more sustainable economy. On the
one hand there is the need to provide funding to those companies developing the solutions to
the challenges we face, on the other hand there is the need to set financial incentives to help
the biggest polluters transform into more sustainable businesses.
While investors can select from a wide range of sustainability strategies, the most
common ones are known as “exclusion,” “best in class,” “engagement” and “thematic” (Busch,
Bauer and Orlitzky, 2016; van Duuren, Plantinga and Scholtens, 2016).2 Oftentimes these

1
Financial Times, 16 January 2019, “BlackRock targeted by fake letter on climate change.”
2
Exclusion is a strict form of negative screening in which companies that engage in the production of
certain products (such as tobacco) or engage in certain business practices (child labour) are
prohibited in the portfolio construction. Best in class approaches rank the companies in each sector
by a selection of sustainability criteria and then only invest in the most sustainable ones. Thematic
approaches seek to invest in themes such as renewable energy by selecting only companies involved
in the production of these goods and services.

Electronic copy available at: https://ssrn.com/abstract=3314906

strategies are combined and layered on top of each other. With the exception of the
engagement approach, all the other approaches involve the allocation of funds in favour of
sustainable companies and the withdrawal of funds from less sustainable companies.
Such allocation may be done out of financial or ethical considerations or a mixture of
both. Examples include the decision by the California State Teachers’ Retirement System
(CalSTRS) to divest from firearms producers and the pledge by almost 1,000 institutional
investors representing more than $6 trillion in assets to divest from fossil fuel assets.3 The latter
campaign seeks to divest from fossil fuel assets for fear these may become ‘stranded assets’
(Caldecott, 2017) once the world transitions to less carbon-intensive power generation.4
However, while an ever-greater number of investors seeks to either divest from, or
engage with, fossil fuel companies in order to reduce the carbon intensity of their portfolios, the
Financial Times (FT) reports that some of the world’s largest asset managers have ramped up
holdings in coal companies.5 This ramp-up is the result of inflows into “passive” index investing
strategies, primarily Exchange Traded Funds (ETFs).6 Index investments typically seek to
minimize their “tracking error,” the degree to which their performance diverges from that of
their benchmark index, by buying all the stocks in the benchmark.7 Asset managers may
therefore seek to abdicate responsibility for the holdings of their ETFs to the index rules.
And indeed, BlackRock explained to the FT that because much of its coal holdings are
in passive funds, they cannot divest and are instead limited to engagement with the companies
in question.8 The large index firms all take the same approach in this respect. The CEO of
State Street Global Advisors, Cyrus Taraporelava also defers to index rules to explain their

3
See https://www.calstrs.com/statement/calstrs-finalizes-divestment-firearms-manufacturers
accessed 30 December 2018. See also: The Guardian, 10 September 2018, “Fossil fuel divestment
funds rise to $6tn.”
4
Stranded assets are “assets that have suffered from unanticipated or premature write-downs,
devaluations, or conversion to liabilities” (Caldecott, Howarth, and McSharry, 2013: 7). Supporting the
case for divestment, is a report by McGlade and Elkins (2015) which shows that global fossil fuel
reserves are three times larger than the level that it will be possible to burn if the world is to have at
least a fifty per cent chance of keeping global warming below 2 °C throughout the twenty-first century.
5
Financial Times, 9 December 2018, “BlackRock, Vanguard, Axa raise coal holdings despite climate
fears – Big asset managers have increased investments since 2015 Paris accord.”
6
ETFs are funds that trade on exchanges like ordinary stocks. During normal trading hours, market
makers show live prices throughout the day, enabling investors to buy and sell funds in real time
(unlike conventional mutual funds, which have cut-off times by which orders have to be submitted,
typically to be executed the following day).
7
For a discussion of index design and tracking error see Frino et al. (2004)
8
Financial Times, 9 December 2018, “BlackRock, Vanguard, Axa raise coal holdings despite climate
fears – Big asset managers have increased investments since 2015 Paris accord.”

Electronic copy available at: https://ssrn.com/abstract=3314906

inability to divest: “We are essentially permanent capital and cannot turn the S&P 500 into the
S&P 499.”9 This is the common wisdom.
There are, however, a multitude of options index funds have at hand to alter the carbon
intensity of their assets under management (AuM). Asset managers can, for example, discount
the fees of low-carbon investments, switch the indices that funds track, switch index providers,
lobby index providers to change the index rules, and discontinue sector funds with extreme
exposure to coal stocks. Because invested funds are sticky, and liquidity is one of the main
attractions of ETFs, launching alternative low-carbon ETFs and expecting consumers to take
the active decision to switch is a flawed solution.
It is crucial that we address the contribution of index investing to sustainable finance
today. Moody’s estimates that between 2021 and 2024 index funds will surpass active funds in
terms of AuM in the U.S..10 Failure to address the responsibility of index funds today will likely
mean that by 2024, the majority of U.S. assets will be invested in products lacking
considerations of sustainability. Index funds may then become holders of last resort, buying up
assets divested by active funds. This paper explains why index funds cannot continue to hide
behind index providers and that adding the threat of exit, to be used alongside engagement,
will increase the chances of any engagement being successful.
This paper contributes to the literature on asset manager capitalism a discussion of
where responsibility sits within the investment chain. To the nascent literature investigating the
governance role of index providers (Rautenberg and Verstein, 2013; Robertson, 2018) as well
as the corporate governance and sustainable finance literatures it contributes a list of policy
measures to address the challenge that sustainability and fiduciary considerations pose to the
asset management industry. The issues discussed in this paper are part of the much larger
debate concerning the role of the firm in society and the extent to which shareholders should
act as their steward (Freeman, 1984; Lazonick and O'Sullivan, 2000; Jensen, 2001; Clark and
Hebb, 2005; Hart and Zingales, 2017; Serafeim, 2017).

2. The Challenge
On the 9th of December 2018, the Guardian Newspaper reported that 414 institutional
investors, representing $31 trillion in assets under management (AuM), had signed a “Global
Investor Statement” to be handed to world leaders at the 24th Conference of the Parties to the

9
Financial Times, 24 July 2018, “Index Funds must be activists to survive – Since we cannot sell, we
have to press management for improvement.”
10
Reuters, 2 February 2017, “Index funds to surpass active fund assets in U.S. by 2024: Moody’s.”

Electronic copy available at: https://ssrn.com/abstract=3314906

United Nations Framework Convention on Climate Change in Poland (COP24).11 However,
on the same day, the FT reported that some of the world’s largest investors, including
BlackRock and Vanguard, had significantly increased their coal holdings since the Paris climate
agreement was signed in November 2016.12
Referencing a report by the UK non-profit organization InfluenceMap, the FT reveals
that a group of large investors had increased their holdings in thermal coal producers by
approximately one fifth between 2016 and 2018. According to InfluenceMap (2018),
BlackRock has both the largest absolute holdings of thermal coal producers and the highest
density of coal holdings. Also listed amongst the top five for thermal coal intensity are Vanguard
and State Street.13
How can this be if, as the FT reports elsewhere, BlackRock itself acknowledged in 2016
that investors cannot ignore climate change and have to act in order to protect their
portfolios?14 The answer can be found in the changes that the asset management industry is
undergoing. In the United States, ETFs have seen their assets increase more than six-fold over
the past decade, from $531bn in 2008 to $3.4 trillion at the end of 2017 (ICI, 2018). The reason
for their popularity is that they offer diversification at low cost and good liquidity. Index
investments aim to track rather than beat the performance of a benchmark index (Braun, 2016).
The inflows into index funds have come at the cost of active funds that have seen large outflows.
Fichtner and Heemskerk (2018) report that from mid-2006 to mid-2017 passive funds saw
inflows of $2.6 trillion, while active funds saw corresponding aggregate outflows of $2.7 trillion.
Due to large economies of scale, three asset managers captured the vast majority of these
inflows: BlackRock, Vanguard and State Street Global Advisors (“The Big Three,” Fichnter et
al., 2017).
The increase in the thermal coal holdings of these asset manager is therefore not a result
of an active decision by the asset manager to purchase these assets, but the result of investors
continuing to reallocate funds from active to passive funds in the time since the Paris climate
agreement. (Figure 1).

11
The Guardian, 9 December 2018, “Largest ever group of global investors call for more action to
meet Paris targets - The group of 414 institutional investors with $31 trillion under management say
governments must take serious steps to cut emissions.”
12
Financial Times, 9 December 2018, “BlackRock, Vanguard, Axa raise coal holdings despite climate
fears – Big asset managers have increased investments since 2015 Paris accord.”
13
Intensity is calculated as tons per dollar of assets under management.
14
Financial Times, 6 September 2016, “BlackRock issues climate change warning – Investors must
adapt their portfolios to combat global warming, says world’s largest asset manager.”

Electronic copy available at: https://ssrn.com/abstract=3314906

Figure 1: Flows into ETFs and out of Active Funds (between COP21 and COP24, $bn)

Source: ICI data.

The InfluenceMap data surveyed 60,000 listed funds and shows that BlackRock’s
thermal coal intensity is approximately fifty percent higher than the average of all of these
funds. So as other funds have divested thermal coal assets, these shares have found their way
into the hands of index funds as a result of the fund flows pictured in Figure 1. As our
understanding of global warming develops, and as social expectations evolve, the responsibility
for holding these thermal coal assets has to sit somewhere. The common wisdom is that nothing
can be done about this because of passive funds’ index rules. However, as I will go on to show
in the remainder of this paper, this is not necessarily the case.

3. Index Investors’ Current Record on Sustainability

The Investment Stewardship Report of BlackRock (2018a) shows that the company categorizes
‘resolutions regarding social and environmental matters that may have an impact on company
operation’ under the grouping ‘Miscellaneous business’. The report further shows that
BlackRock globally voted on 868 such proposals in the period 1 July 2017 until 30 June 2018,
and votes against management just 5% of the time. Furthermore, the FT reports that
BlackRock, the world’s biggest asset manager, has never filed a shareholder proposal.15 This

15
Financial Times, 24 November 2018, “BlackRock takes on proxy advisers in dispute over investor
rights – Fund manager flags up suggested improvements to voting processes and shareholder
proposals.”

Electronic copy available at: https://ssrn.com/abstract=3314906

restraint from submission of shareholder proposals is, however, characteristic of most large asset
managers, who defer the filing of proposals to activist investors with specialist knowledge.
If one accepts the common wisdom that ‘passive’ investors cannot sell because the rules
of the indices they track are set in stone, then one would expect them to make even greater use
of their voice. In this regard they are saying the right things. State Street Global Advisors, for
example, is talking about the need for index funds to become activists, and about the need to
‘press management for improvements.’16 However, when it comes to actions, at least with
regards to climate change, their record appears mixed.
The 2017 shareholder vote at ExxonMobil marked a watershed moment as the
company’s management was defeated in a shareholder vote calling for the commissioning of a
report into the risk that climate-change-mitigation policies could have on the company’s
business prospects. According to sources quoted in the Washington Post, the Big Three asset
managers had all voted in favour of the shareholder proposal resulting in 62.3% of the shares
backing the proposal.17 This was the first time that the big passive managers took such a
unanimous decision on climate change.
This voting action by the Big Three show that if index investors see governance failures,
such as the refusal by ExxonMobil to engage, they will vote against management. In general,
however, while the asset management industry demands good corporate governance and
transparency, most investors stop short of demanding changes to companies’ business strategy.
Actual operational issues are typically left to management.18 Also noteworthy is the fact that
none of the Big Three are signatories of the Climate Action 100+ group.19 This is despite being
signatory does not require divestment of any assets but instead a focus on engagement with
corporates engaged in carbon-intensive industries.

16
Financial Times, 24 July 2018, ‘Index Funds must be activists to survive – Since we cannot sell, we
have to press management for improvement’.
17
The Washington Post, 31 May 2017, “Financial firms lead shareholder rebellion against ExxonMobil
climate change policies.”
18
In the US the “business judgement rule” is likely also responsible for the lack of shareholder
involvement in corporate strategy. The rule insulates corporate directors from liability from their
business decisions and “this authority of the board of directors means that they will virtually have no
powers to intervene in the business affairs of the corporation, even with regard to some ‘hybrid’
decisions such as a hostile takeover, where heightened agency problems may arise between
managers and shareholders” (Gurrea-Martínez, 2016).
19
For further details on Climate Action 100+, see: http://www.climateaction100.org/ accessed 2
January 2019.

Electronic copy available at: https://ssrn.com/abstract=3314906

4. Why Voice needs Exit
The standard view, perpetuated by the asset managers themselves, is that index funds cannot
exit as index providers tell them what stocks to hold. Instead, since they take their stewardship
responsibilities seriously, index funds make use of their voice to engage with corporations. In
this section I will briefly review the literature on engagement before setting out why engagement
needs the implicit threat of exit to maximise its chance of success.
The interaction of voice and exit is heavily influenced by the work of Hirschman (1970)
with the result that exit is seen as a separate or sequential action that is the consequence of
unsatisfactory engagement (Withey and Cooper, 1989). However, in their study of shareholder
engagement by social and religious investors, Goodman et al. (2014) find that exit should be
seen as being part of voice. They document cases where investors engaged subsequently to
divesting and highlight that divestment may give a publicity boost, which can invigorate
campaigns to the point where they become successful at a point after divestment has occurred.
The case studies provided by Goodman et al. (2014) further show that, contrary to
popular belief, investors that sell their shares do not lose their “seat at the table”. They may
lose their proxy voting rights, but they are still able to engage both publicly and privately.
Indeed, any investor, whether a current shareholder or not, represent a potential future buyer
of shares and thus corporates remain incentivised to engage with them. Their typically patient
investment and engagement style provides index investors with greater salience while also
making them particularly desirable shareholders. Divestment, or the threat of it, may thus offer
index investors a means of capitalizing on their reputation.
The literature on governance by large shareholders (Gopalan, 2005; Edmans, 2009;
Admati and Pfleiderer, 2009, Edmans and Holderness, 2016) typically assumes that a “free-
rider” problem arises from the fact that large “monitoring” costs are associated with
engagement while the benefits accrue to all shareholders alike. This raises the prospect for exit
to operate alongside voice, and the threat of multiple blockholders seeking to competitively sell
out of their holdings ‘strengthens the threat of disciplinary trading’ (Edmans and Manso, 2011:
2395). Indeed, Palmiter (2002) shows that the threat of exit in itself may suffice as a form of
activism. Similarly, Admati and Pfleiderer state that the ‘threat of exit may be important in
making "jawboning" activities and behind-the-scenes negotiation with management effective’
(2009: 2646).
A final point supporting the need for the option to exit is to be found in research by
Schmidt and Fahlenbrach (2017). The authors find that increases in passive ownership lead to
higher agency costs as corporate executives engage in more value-destroying mergers and

Electronic copy available at: https://ssrn.com/abstract=3314906

acquisition decisions. Hirschman (1970) himself posits that complete loyalty to the corporation
can limit the effectiveness of voice as it can lead the corporation to take the relationship for
granted.

5. The Relationship between Index Providers and Asset Managers

The popularity of ETFs has caused a boom in the index industry to the point where the number
of market indices today exceeds the number of U.S. stocks.20 But who is responsible for the
stocks that make it into an index? Is it the index provider, the index investor, or both? Before
we can answer this question, some background information about index providers and context
as to the nature of their relationships with asset managers is necessary.
While credit ratings agencies (Levich et al., 2002; Sinclair, 2005; White, 2010) and
proxy advisors (Choi et al., 2010; Malenko and Shen, 2016; Sauerwald et al., 2018) have been
subjected to comprehensive academic analysis, the governance role of index providers has to
date received limited attention in the academic literature. The industry structure is oligopolistic,
with just three companies, Standards and Poor’s (S&P), MSCI, and FTSE Russell accounting
for a combined 78.1% of the $2.7 billion in index industry revenues in 2017.21 Index providers
earn the majority of their fee income from subscription fees and licensing fees. Subscription
fees arise when investors sign-up for access to index research and constituency data. Licensing
fees arise when asset managers launch investment products based on third-party indices.
Licensing fees are typically charged on the assets under management tracking the indices.22
The financial fortunes of the big asset management firms and index providers are
symbiotic. MSCI reports that for its fiscal year 2017, its ten largest clients accounted for 27.8%
and that its largest client, BlackRock, accounted for 11.5% of total revenues. MSCI further
states that 95.3% of the revenues earned from BlackRock came from fees based on the assets
in BlackRock ETFs that track MSCI indices (MSCI, 2018a). Importantly, BlackRock
accounted for 20 per cent of the Index segment’s operating income. In an interview with
Bloomberg, Mark Wiedman, the global head of iShares and index investments at BlackRock

20
Bloomberg News, 12 May 2017, “There Are Now More Indexes Than Stocks”; Bloomberg Markets
Magazine, 27 November 2017, “Index Providers Rule the World—For Now, at Least.”
21
Data from consulting company Burton-Taylor, https://burton-taylor.com/global-index-industry-
revenues-total-2-7-billion-in-2017-new-burton-taylor-benchmark-study-analyzes-index-industry-trends-
and-factors-driving-revenue-growth/ (Accessed 5 January 2019). S&P is, of course, also one of the
“big three” credit ratings agencies.
22
MSCI explains their business model as follows: “Our principal business model is to license annual,
recurring subscriptions to our offerings for a fee, which is, in a majority of cases, paid in advance.
Fees may vary by offering, number of users or volume of service. We also charge clients to use our
indixes as the basis for index-linked investment products, such as ETFs, or as the basis for passively
managed funds and separated accounts” (MSCI, 2018: 4-5).

Electronic copy available at: https://ssrn.com/abstract=3314906

appears to confirm the quality of the relationship between BlackRock and MSCI when he says
that “One of our close partners is MSCI. […] Often, it’ll be MSCI that brings us to a client. In
that case, they’ve delivered huge value to us, and their client tends to think in MSCI terms.”23
While a detailed analysis of the role of index providers in private governance is beyond
the scope of this paper, they can be considered alongside proxy advisors and credit ratings.
Such ‘private authorities’ (Kerwer, 2001) act as ‘gatekeepers’ of capital (Sinclair, 2005) and
‘invisible switchmen’ (Kerwer, 2001) of capital flows. Index providers are the equity market
equivalent of the gatekeeper function fulfilled by credit ratings agencies in the bond market in
that they shape “the norms of what’s considered acceptable in international finance” (Alloway
et al., 2018).24
Besides traditional factors such as market capitalisation, trading liquidity, industry
membership and the domicile of a company, there is an increasing debate as to whether other
factors such as the quality of corporate governance should influence how a company is indexed.
Several index providers either already have, or are considering, to exclude companies that issue
shares without voting rights. One such example is the social media company Snap Inc, which
listed on the New York Stock Exchange on March 2nd, 2017. On the 31st of July of 2017 S&P
announced that it will start excluding companies that issue multiple classes of stock. While this
ruling does not apply to stocks already in S&P indices, such as Berkshire Hathaway or Alphabet,
it does prevent Snap from gaining access in the future.25 S&P’s decision was followed by FTSE
Russell, which announced that it would be commencing a consultation on the issue. The results
of this consultation, published in July 2017, showed that “68% of the respondents agreed that
some minimum hurdle for the percentage of voting rights in public hands should be imposed”
(FTSE Russell, 2017: 2). In its conclusion, FTSE Russell stated that it believes “the SNAP Inc.
IPO set a dangerous precedent for companies to come to the market with few, if any, voting
rights” and that the “principle set out here effectively draws a principled line in the sand” (FTSE
Russell, 2017: 6).

23
Bloomberg Markets Magazine, 27 November 2018, “Index Providers Rule the World – For Now, at
Least.”
24
Stock exchanges are further examples of such private authorities. However, with the business
model of stock exchanges conflicted due to their desire to attract companies to list on their
exchanges, the extent to which they can ensure corporate oversight is questionable. Nasdaq, for
example, has been campaigning for stricter regulation of proxy advisors and for measures to curtail
the number of shareholder proposals. See: https://listingcenter.nasdaq.com/ClearinghouseArticle/Its-
Time-to-Fix-the-Proxy-Process-1661
25
Reuters business news, 1 August 2017, “S&P 500 to exclude Snap after voting rights debate.”

10

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 While other index providers such as FTSE Russell and S&P have barred companies
with unequal voting rights, MSCI has decided on a different approach.26 After a lengthy 18-
month review period, the result of the MSCI review was disappointing for many shareholder
rights advocates.27 MSCI decided to allow the likes of Snap Inc to remain in its existing indices
and instead issue alternative indices excluding companies with unequal voting rights. However,
as I will explain in the next section, such alternative products do not present viable solution to
address issues of responsibility due to the fact that the majority of liquidity and assets under
management will continue to remain in the default blue-chip benchmark indices.
The different treatment of voting rights is illustrative of the fact that index construction
is oftentimes a judgement call rather than a science. In one of the only papers looking at the
governance role of index providers, Robertson (2018) takes issue with the fact that indices are
generally treated as passive, yet “far from being passive, these indices represent the deliberate
decisions made by their managers” (2018: 3). This argument is confirmed by Howard Marks,
co-founder of Oaktree Capital Management LP., who explains that “[s]omebody is making
very active decisions about which stocks will be in each index or ‘passive’ product.”28 Finally,
Rauterberg and Verstein show that “human discretion and value judgement to be essential
ingredients in even the most “objective” indices” (2014: 1).
Indices are not a genuinely passive ‘buy and hold’ strategy since indices often grant the
index provider a degree of discretion, and some indices, such as the Dow Industrial Average
do not even have quantitative rules for selecting constituents, Robertson (2018) therefore
advocates equating index investment to ‘delegated management’. In another telling example,
she describes how in the period from January 1, 2015 to April 30, 2018 S&P made at least 8
changes to the methodology of the S&P 500 index.
The decision by MSCI to not adjust existing indices for differences in voting rights is
illustrative of the balance of power in the relationship between BlackRock and MSCI.
BlackRock had responded to the MSCI consultation with a letter outlining why the company
believes “policymakers, not index providers, should set corporate governance standards”
(2018b: 1). MSCI’s explanation for its decision acknowledges the position put forward by
BlackRock “while many participants felt strongly that benchmarks should be adjusted to reflect
unequal voting structures, other participants highlighted that the question of unequal voting

26
S&P does not allow new entrants to its indices with multiple share classes, while FTSE Russell
requires companies to offer unrestricted shareholders at least 5% of the voting rights.
27
IPE, 1 November 2018, “Legal & General hits out at MSCI’s dual share class index move.”
28
Bloomberg Markets Magazine, 27 November 2018, “Index Providers Rule the World – For Now, at
Least.”

11

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rights should be addressed holistically by the stakeholders that are responsible for operating,
regulating and investing in equity markets. These stakeholders include, among others, securities
regulators, stock exchanges, asset owners and asset managers” (MSCI, 2018b).
Finally, it is worth noting that the influence of index providers extends beyond index
funds to active funds. While there is a growing number of ‘unconstrained’ investment mandates,
most asset managers either have formal investment benchmarks or informal internal
benchmarks by which they are evaluated. Active fund managers will typically have a limit on
the “tracking risk” versus their benchmark index they are prepared (or allowed) to take. A fund
manager that takes active positions of one percentage point, benchmarked to an index that
contains Apple Inc with a weight of 3%, may therefore only ever vary the weight of Apple in a
range from 2% to 4%. In fact, some asset managers take such limited tracking risk, that they
have been referred to as “closet trackers” (Cremers and Petajisto, 2009). The prevalence of
such closet trackers, estimated at between 5 and 15% of funds in Europe, has led regulators to
undertake investigations.29

6. Altering the Carbon Footprint of Index Investors

Broadly speaking, asset managers have two options to reduce the carbon footprint of their
investments. The first is to add to the product portfolio a selection of low-carbon funds or to
close funds with extreme levels of carbon-intensity, and then either leave it to their customers
to switch or seek to support switching through the provision of pricing incentives. The second
solution is to alter the construction of their existing products (funds) by removing carbon-
intensive stocks from their portfolios. I will now consider each of these solutions in turn.
Asset manager’s preferred solution to tackle the carbon intensity of their product
portfolio is to add low-carbon products to their product offering. The VanEck Green Bond
ETF (“GRNB”) and BlackRock’s iShares Global Green Bond ETFs provide examples of such
product additions.30 These ETF consist of “green bonds,” which are bonds that finance projects
linked to climate change solutions. A closely related alternative is a second line of ETFs that
runs in parallel to existing ETFs but excludes certain stocks such as, for example, shares of
thermal coal producers. Such an approach would implicitly seek to pass the issue of
responsibility back to the individual making the investment decision. Yet without the relevant

29
European Securities and Markets Authority (ESMA): “Statement – Supervisory work on potential
closet index tracking"
https://www.efama.org/Publications/Statistics/Other%20Reports/EFAMAReportClosetIndexFunds.pdf
30
For further details see: https://www.vaneck.com/vaneck-grnb-best-etf.pdf (accessed 4 January
2019)

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education and advertising spend such products would struggle for ‘shelf space,’ while individual
investors for their part are already “overwhelmed by the sheer number of ETF products”
(Bhattacharya, Loos, Meyer, and Hackethal, 2017: 1219).
More importantly, attempts to issue such twin products fail to take account of one of
the main reasons why investors employ ETFs: liquidity. With few exceptions, for each
benchmark index, there are only ever one, or at most two, ETFs that attract the vast majority
of inflows. These ETFs dominate not just the assets but also the trading flows and public
attention, leaving little space for alternative products. Broman and Shum (2018) document that
highly liquid ETFs are particularly attractive to investors and that relative liquidity predicts net
fund flows. Liquidity is a contributor to transaction costs. And particularly for institutional
investors, trading costs are a major consideration and finding the optimal trading venue and
product is therefore key (Madhaven, 2016). This is, therefore, also the reason that MSCI’s
decision to create alternative indices, which exclude stocks without voting rights, is likely to be
unsuccessful.
The preceding solutions fall short of enabling a step-change in asset managers’ carbon
footprints. For this to happen, the big benchmark products that make up the majority of asset
managers’ assets will need to be altered. In practice there are three ways in which this can
happen. Unlike investors in active funds, who expect an outperformance of the fund versus its
benchmark, index investors anticipate their investments matching (but not beating) the
performance of the reference index. Index fund managers will therefore seek to minimize the
deviation of their funds’ performance (‘tracking error’) from that of the benchmark index. To
do so they will generally buy most if not all of the stocks contained in the index.31 However,
while each fund company will have different terms and conditions in their funds’
documentation, there will generally be sufficient leeway provided to enable the portfolio
manager to refrain from buying a small number of stocks.
The terms of the $726.4 billion Vanguard Total Stock Market Index Fund Investor
Shares (VTSMX), for example, explain that the fund “employs an indexing investment
approach designed to track the performance of the CRSP US Total Market Index” and that it
“invests by sampling the index, meaning that it holds a broadly diversified collection of
securities that, in the aggregate, approximates the full Index in terms of key characteristics.”32

31
One notable exception is the case of “swap-backed” ETFs in which the fund manager buys a swap
that replicates the index performance from an investment bank.
32
Vanguard, https://investor.vanguard.com/mutual-funds/profile/portfolio/vtsmx (accessed 5 January
2019).

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The key word here is “sampling.” They do not have to hold every stock in the index so long as
the fund in aggregate approximates the full index. In fact, as of January 2019, the fund held
3599 of the 3639 stocks included in its benchmark index (the “CRSP US Total Market Index”).
Staying with the example of Vanguard, the asset manager holds approximately 6.7%
of the outstanding shares of the US coal company Peabody Energy, as of January 2019. The
aforementioned Vanguard Total Stock Market Index Fund Investor Shares (VTSMX) is
responsible for more than a third (2.5%) of this holding. This Peabody Energy holding equates
to approximately 0.015% of the fund’s $726.4 billion holdings. Arch Coal Inc is another US
coal company contained in the fund. Here too the fund owns approximately 2,5% of the
outstanding shares, which due to the company’s smaller market capitalisation, equates to
approximately 0.005% of the funds’ assets. Together the two coal stocks therefore represent
just 0.02% of the funds’ assets and their removal would therefore only increase the tracking
error of this fund marginally.33
Should asset managers nevertheless be concerned about the small increase in tracking
error that results from excluding these two stocks representing 0.02% of the fund, or fear issues
of fiduciary duty arising from such an exclusion, there are two alternative ways of ridding index
funds of coal assets: removing coal stocks from benchmark indices or switching to coal-free
indices.34 The former approach involves asset managers lobbying index providers, while the
latter involves index funds requesting index providers create coal-free indices and then
switching their ETFs to these adjusted benchmarks.
How realistic is it for the Big Three asset managers to call on the big index providers to
modify their index rules to take account of changing social expectations with regards to
investments in, for example, thermal coal? Technically, switching is possible. Fund
documentation typically accounts for the possibility of having to switch indices or index
providers. In practice, switching indices may require that investors be contacted, which would
have moderate legal and postage costs attached to it. The real issue arises from a branding
perspective. As outlined in the previous section, this brand recognition poses a substantial
hurdle for asset managers seeking to switch index providers. If an asset manager were to switch
to an alternative index provider and have them construct an index consisting of the 500 largest

33
However, if these two coal stocks were to double in one year, the fund would possibly underperform
its benchmark index by 0.02% or more, which in the world of index funds is a meaningful amount.
34
For a debate of fiduciary duty in relation to ESG and asset managers more generally, see Sanders
(2014) and Jahnke (2019) respectively.

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US companies, such a fund might struggle for recognition, as retail investors continue to search
for “S&P 500” ETFs.
The biggest asset managers, however, represent an exception. Their own brands are so
strong that a “BlackRock US 500 Index” or a “Vanguard US 500 Index” could be a successful
product. But far from this being just a hypothetical consideration, there are multiple examples
of ‘self-indexing’ in practice. The competition between asset managers has become so intense
that asset managers are continually looking for ways to cut costs and lower management fees
in order to take market share. This competition has led to the formerly symbiotic relationship
between the big asset managers and index providers coming under some strain. In August 2018,
Fidelity launched two self-indexed funds that charge investors no explicit fees. In an interview
with the FT, the former boss of State Street Global Advisors, described Fidelity’s decision as “a
shot across the bow” to index providers and explained that “if you look at where costs have
been coming down, it’s the management fees. Where they have not is the cost of using
indices.”35
Another example is provided by Vanguard. Quoting a team member of Vanguard’s
indexing group, Bloomberg explains that “’hypercompetition’ among providers means that if
Vanguard doesn’t like your index, there are plenty of others to choose from.”36 And Vanguard
has shown that it means business. Vanguard announced in October 2012 that it was changing
the target benchmarks for 22 index funds previously benchmarked to MSCI indices. Six of the
funds were switched to FTSE Russell indices, while the remaining sixteen were switched to new
benchmarks developed by the University of Chicago's Center for Research in Security Prices
(CRSP).37
In addition to Fidelity’s decision to self-index and Vanguard’s decision to switch index
providers, State Street Global Advisors has also opted for changes to some of its indices. In
October 2017, State Street dropped Russell indices for three of its ETFs and instead opted for
a self-indexing solution. This required a name-change for the affected products, and the SPDR
Russell 3,000, SPDR Russell 1,000 and SPDR Russell 2,000 ETFs were renamed to SPDR
Portfolio Total Stock Market ETF, the SPDR Portfolio Large Cap ETF and SPDR Portfolio
Small Cap ETF respectively.38 Following the switch State Street was able to lower the fees on

35
Financial Times, 10 September 2018, “State Street chief takes aim at high-cost index providers.”
36
Bloomberg Markets Magazine, 27 November 2018, “Index Providers Rule the World – For Now, at
Least.”
37
Vanguard. Available at:
http://www.crsp.com/files/Vanguard_Benchmark_Change_Press_Release.pdf
38
Financial Times, 16 October 2017, “State Street shifts to home-grown indices for three US stock
ETFs.”

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the first two funds from 0.10 percent to 0.03 percent and on the Small Cap ETF from 0.10 per
cent to 0.05 percent.
These changes demonstrate a number of important points. Firstly, it is possible for asset
managers to change index providers. Secondly, the instances of self-indexing indicate that the
influence of index providers is waning while that of asset managers is rising. With regards to
the issue of social responsibility, this means that the picture is becoming clearer and an
increasing amount of responsibility is concentrating with asset managers.
An additional challenge facing asset manager is that in responding to social concerns
they make themselves vulnerable to criticism from corporates. Yet the current approach of
seeking to be a neutral mass sitting between the two charged poles of business and society is an
impossible feat. As attitudes shift a formerly neutral position is no longer neutral and inactivity,
for example on coal divestment, becomes an active choice. For asset managers it is important
to understand that they cannot free themselves of this responsibility through the use of an agent
(in this case the index provider). The responsibility of what stocks are contained within the
benchmark indices their funds tracks therefore rests entirely with the asset manager. Contrary
to the common wisdom, indices are not God-given as Mohamed El-Erian, chief economic
adviser at Allianz SE, explains.39

7. Conclusion
“Convergence to global standards takes place when key actors in the investment value chain demand levels of
corporate and social behaviour greater than those currently consistent with countries’ regulatory frameworks”
(Hebb, 2008:70).

Today responsibility for investments is spread out across several actors, including individual
and institutional asset owners, stock exchanges, index providers, proxy advisors and asset
managers. This paper has set out how asset managers can do their part to fulfil the significant
responsibility they hold. It has documented various ways in which index investors can sell
individual stock holdings, enabling them to have the threat of exit as a tool to strengthen their
voice.

39
Bloomberg Markets Magazine, 27 November 2018, “Index Providers Rule the World – For Now, at
Least.”

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 Moody’s forecasts that index investors will surpass active funds in the US by 2024, so
the success of shareholder proposals will increasingly be decided by how index funds vote.40
Even the ‘father’ of index investing, Jack Bogle the late founder of Vanguard, recently warned
in a Wall Street Journal Op-ed that there will be major issues once index investors hold voting
control of virtually every large US corporation.
Referencing a recent paper by Coates (2018), Bogle lists a number of solutions, virtually
all of which involve some form of regulatory response. Bogle emphasizes the value long-term
focussed index funds bring to society as a “much needed counterweight to the short-termism
favored by so many market participants.”41 Yet it is exactly this long term focus that index
investors have largely failed to express through discernible actions to date. They have yet to
match the long-term investment behaviour of their ultimate investors with support for equally
long-term policies. Not changing while social norms evolve is not the same as remaining
neutral, it is taking sides.

40
Moody’s, 2 February 2017, “Moody's: Passive investing to overtake active in just four to seven
years in US; global traction to pick up,” available at: https://www.moodys.com/research/Moodys-
Passive-investing-to-overtake-active-in-just-four-to-PR_361541
41
The Wall Street Journal, 29 November 2018, “Bogle Sounds a Warning on Index Funds.”

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