What’s in Your Index Fund?

First, let’s get a definitional issue out of the way. The authors wrote that “index funds typically track a broad group of stocks, like all the companies in the Dow Jones industrial average or the S.&P. 500.”

That’s mostly right, but not quite precise enough for our needs. Technically speaking, index funds don’t track a nebulous groups of stocks, but rather very specific indexes. And the difference between indexes and “broad groups of stocks” is significant, for a variety of important reasons.

For starters, index-based mutual funds and exchange-traded funds get assembled using a particular methodology that determines the specific holdings in that index. These are usually — but not always — disclosed in the funds’ prospectuses. (Clearly, there is room for improvement in this area and, as I noted above, I fully endorse transparency.)

The index itself is typically — though not always — created and maintained by another firm, separate from the company that manages the fund. They too publish their selection methodology and what determines their holdings, rules and timings of changes. If the SEC wants to mandate more timely disclosures of these elements, I believe it would find lots of support from the investor community.

By way of contrast: The approach used by indexers is much more transparent than those often used by active managers who make changes in their fund holdings seemingly at random, and often in ways that hurt investment performance. Index funds tend to have less subjectivity and follow a more rules-based approach than active investment management does.

Let’s say you own a major index in an ETF. The index might be the Standard & Poor’s 500 Index, the Russell 2000 Index or the MSCI Emerging Markets Index. An enormous amount of specific detail is available about each index, either from the index company or the mutual fund or ETF provider. The competition in the market is intense, which is reflected in part by the cutthroat fee wars. If greater transparency was demanded by investors, someone would surely have provided it as a competitive advantage.

More troubling, and perplexing, is the authors’ assertion that: “The indexes these funds are based on may not be as neutral as they seem.” The op-ed then goes on to remind readers about the Libor scandal in which bankers rigged benchmark interest rates.

It does warrant repeating that index funds are not neutral and no one who understood them has ever said they were. Indexes are manufactured products, created by humans making specific investment decisions within the confines of rules-driven determinations. That may make them more efficient and less subject to the behavioral errors that befall so many active funds, but it doesn’t make them neutral.

Take the S&P 500 for example: It is made up of 1) stocks; 2) of companies based in the U. S.; 3) that are among the largest in the nation; 4) which have been picked by the S&P selection committee; and 5) are weighted on a market-capitalization basis. There is literally nothing in the preceding statement that can remotely be construed as anything approaching neutrality. We can perform the same exercise with any index, from the MSCI Emerging Markets Index to the Dow Jones Industrial Average to the Russell 3000 Index.

One last thing to consider: Low-cost index investing has been the hot trend since the financial crisis. However, change seems to be the only constant in equity markets. Some folks have argued that direct indexing is the next innovation that will disrupt the financial industry. This entails matching the performance of an index by buying the underlying shares, typically minus what the investor doesn’t like or need. This method is 100 percent transparent, taking disclosure to the next level.

Those of us who believe in the competition of ideas and market-based solutions see the merit of greater disclosure and transparency, which is one of the beneficial features of index investing. It hardly seems objectionable or controversial if the SEC wants more of it.