The Tell: How trillion-dollar stock-market index funds are vulnerable to manipulation that ‘could harm American investors’

Mutual Funds

Dangers may lurk in index funds, a popular area of the stock market known for their recent and consistent record of outperformance against actively managed funds, according to experts.

A recent op-ed in the New York Times cautions that passive index funds may be vulnerable to bias, and possibly manipulation, as interest in those funds has ballooned over the past decade.

Read: Opinion: Why the ‘mania’ for index funds won’t derail the stock market

This is how Robert J. Jackson Jr., a member of the Securities and Exchange Commission, and Steven Davidoff Solomon, a professor at the University of California, Berkeley, Law School, put it in an article published Feb. 18 in the New York Times:

But there’s a problem: The indexes these funds are based on may not be as neutral as they seem. The firms that devise these indexes face little regulatory scrutiny and can face significant conflicts of interest, which have the potential to harm American investors.

For instance, MSCI added Chinese issuers to its emerging markets index after what The Wall Street Journal said was pressure from the Chinese government. Another conflict is when the index and fund are run by the same managers, which can be the case for highly customized indexes.

Jackson and Solomon added in the Times article:

Conflicts of interest should worry anyone who is invested in index funds, which includes many Americans with retirement accounts. Index providers have enormous power. The decision to include a company in the S&P 500, for example, results in a reallocation of billions of dollars of investors’ money. The average company added to the S&P 500 gains value; when it’s removed, its share price drops as index funds sell their holdings.

By and large, investors in recent years have left actively managed strategies in favor of passive ones in vehicles like exchange-traded funds, or ETFs, that track the Dow Jones Industrial Average

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and the S&P 500 index

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for example. Those include passive ETFs like the SPDR Dow Jones Industrial Average ETF Trust

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known by its ticker “DIA,” and the SPDR S&P 500 ETF Trust

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, known as “SPY.”

Active management had been the standard on Wall Street, and it was tremendously popular in the dot-com era, when high-flying internet stocks minted star money managers. However, in the current expansion, the old order has been disrupted by passive vehicles — perhaps forever.

Interest and money flows have grown because of both the outperformance against their actively traded counterparts, like hedge funds and mutual funds, and their relatively low costs. Such passive ETFs track an index by composition and proportion and aren’t intended to beat a benchmark but simply reflect its moves. Actively managed funds, as Morningstar said in a report last summer, have “failed to survive and beat their benchmarks, especially over longer time horizons,” particularly when fees and other costs are accounted for.

Morningstar said the growth of ETFs has been driven by this massive shift to passive investing, with the likes of Vanguard, founded by John Bogle, and BlackRock

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According to Morningstar, total assets in U.S. mutual funds and ETFs reached a record of just over $18 trillion at the end of 2017, a tripling of assets from $5.5 trillion just nine years ago. Nearly $6.7 trillion, or a third of those assets, resided in passive funds at that time, the data provider said.

To be sure, not everyone agrees with the views shared by Jackson and Solomon.

“Hard to imagine an investment more transparent than index funds that publish holdings and rule on a daily basis. Investors that want to understand what’s inside need only do some homework. While we agree there is less regulatory clarity on what stocks fit the criteria the index uses, there’s more than enough info to see the output,” CFRA Research Director of ETF & Mutual Fund Research Todd Rosenbluth told MarketWatch via email on Tuesday.

Rosenbluth said examples offered by the authors in the Times op-ed “do not seem to apply…to plain vanilla funds that investors primarily have exposure to.”

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