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New Year Resolutions: Index firms can no longer ignore gross human rights abuses in mainstream indices

The idea that indices can be purely a measure of economic activity is under scrutiny

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Responsible Resolutions: This is the latest article in a series from sustainable finance practitioners about their hopes for the New Year.

The decade-long rally in equities has seen low-cost, passive investment solutions deliver triple-digit returns which actively managed strategies have struggled to match. 

It can be a no-brainer for investors. Apart from healthy returns and low fees, passive funds offer a simple, no-frills solution over strategies of increasing complexity and uncertain returns.

Last year, the volume of passively managed US equities surpassed their actively managed counterparts for the first time

Now, major index providers have been dubbed “the biggest power brokers in the industry” by the likes of the Wall Street Journal.

But if the RI community had hoped that incumbent providers would use this clout to introduce even basic human rights standards within mainstream benchmarks, they would be disappointed.

Providers maintain, in the words of MSCI’s CEO Henry Fernandez, that they should be allowed to “measure the performance of all eligible publicly traded securities”, without making “any subjective judgement regarding the company’s intrinsic value or business practice”.

But is this is a defensible position for the de facto gatekeepers of trillions of dollars in global capital?

Through the most widely tracked, key market indices, unwitting investors can find themselves supporting the worst human rights violations such as slave and child labour, state-run concentration camps, illegal land confiscation and forced displacement, and the manufacture of banned arms.

Yet the three major index providers have been among the most vocal advocates for ESG investing, with a string of major ESG acquisitions to prove it. But the explosion of ESG-focused product lines has had little to no influence on the calculation of mainstream indices. 

“Our indices address the needs of a diverse universe of market participants and no particular index is a ‘one-size-fits-all’ solution to investing or benchmarking,” said S&P when asked to account for the presence controversial weaponry – such as landmines and cluster bombs – within its products.

Catering to investors of all stripes has been lucrative and the share prices of the index providers have boomed.

In 2019, MSCI increased the weighting of all China listed A-shares by a factor of four, bringing in additional foreign investment estimated to have topped $80bn into domestic markets. 

"If you can take a view on eligibility criteria such as free float voting, why can’t you take a view on activities banned by international treaties and against societal norms?" -- Laurent Ramsey, CEO of Pictet Asset Management

Among the move’s beneficiaries were Hikvision and Dahua Vision, contractors for state-run concentration camps in which Muslim minorities have been subjected to torture and brainwashing intended to eradicate their culture.

MSCI’s Fernandez, defended the decision in a letter to US lawmaker Marco Rubio, saying the move did not contravene any US law or regulations. 

“Companies are included or removed from an index solely on the basis of objective rules … such as company size, security liquidity and free float requirements.

“Asset managers are free to select any index of their choice and may elect to mirror the index (passive management) or deviate from the index to attempt to outperform it or for ethical or governance or other considerations (active management).”

But it’s not that simple, says a $9trn investor coalition lobbying for the removal of banned controversial weapons from mainstream indices.

Although there are weapons-free versions of major indices, the Swiss Sustainable Finance-fronted group said, they carry additional costs that passive investors might struggle to meet. 

Many others may be altogether oblivious of their exposure to such human rights risks. It follows that cost-conscious investors are unlikely to conduct much due diligence, particularly for broad market indices where constituents can run up to the thousands.

For active investors, deviating from a benchmark on human rights grounds introduces tracking error which may or may not be correlated with increased returns. Fund managers can therefore be incentivised to replicate the exposure of benchmark, despite the presence clear human rights violations, to avoid the risk of underperformance.

Laurent Ramsey, CEO of Pictet Asset Management and a coordinator of the investor campaign said to RI: “Index providers support the manufacturing of weapons banned under international treaties by providing cheap and easy access to capital. 

“If you can take a view on eligibility criteria such as free float voting, why can’t you take a view on activities banned by international treaties and against societal norms?”

Unlike the ‘Social’ criteria in ESG investing which allows for a variety of approaches, the human rights protected by international treaties – that to life, liberty, freedom from torture, persecution, slavery and so on – are much more foundational and describe the very limits of lawful behaviour.

Index providers who ignore clear and repeated violations of these rights by their constituents provide such enterprises legitimacy and access to capital. Responsible investors cannot in good faith consider such actors credible arbiters of ESG and corporate responsibility.

Copyright © 2020 RGM.