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What’s Really in Your Index Fund?

Feb. 18, 2019

Investors love index funds, but they may not be as transparent as they seem.

By Robert J. Jackson Jr. and Steven Davidoff Solomon

Op-Ed in New York Times, February 18, 2019

John Bogle, the father of low-cost investing, once said that the index fund was the “most successful innovation — especially for investors — in modern financial history.”

It’s easy to see why. Index funds typically track a broad group of stocks, like all the companies in the Dow Jones industrial average or the S.&P. 500. Rather than trying to choose one or two winning stocks, or relying on the expertise of a mutual fund manager to do so, investors in index funds can buy a range of businesses and hold them to capture the long-term growth of the market. Because index funds generally don’t need ace stock pickers, they charge rock-bottom fees. Index funds are now the dominant force in investing,holding trillions of dollars of American assets.

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.

The Wall Street Journal recently reported that MSCI, one of the largest index providers in the United States, added Chinese issuers to its Emerging Markets Index after the Chinese government threatened to curtail MSCI’s business in the country. (MSCI told The Journal that its process for choosing firms in its index is “transparent and objective” and includes safeguards to maintain those standards.)

Clearly, there needs to be transparency and accountability in index providers’ decisions.

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.

Even more worrying is recent research by Prof. Adriana Robertsonof the University of Toronto, who documents the rise of highly customized indexes, which are developed for the use of a single fund. She shows that the index and the fund are frequently run by the same managers.

Indexes like these start to look less like the objective benchmarks investors often believe they’re getting. Investors may not understand how the index works or whether it may be susceptible to undue influence.

We saw the real costs of benchmark manipulation in the Libor-rigging scandal. In 2012, settlements with regulators and the Justice Department revealed that some of the world’s most influential banks had manipulated the Libor benchmark, which is used to determine borrowing costs across the economy. The abuses allowed banks to extract excess profits while raising interest costs for American homeowners and students.

In response, the Commodity Futures Trading Commission, under Commissioner Rostin Behnam, established a group to reform such benchmarks. There is no such group overseeing stock market indexes. While there are global standards for how indexes should be governed, American law remains remarkably silent on the subject.

There certainly exists potential for manipulation. Index providers generally have wide leeway when choosing the individual companies that make up their indexes and how they are weighted. Some well-known indexes have established committees to decide which companies are included; for instance, the stocks in the S.&P. 500 index, which is tracked by mutual funds holding more than $1 trillion in assets, are chosen by committee. But these committees have enormous discretion.

Indexes have influence over stock prices that even the largest investors can only envy. Given the conflicts of interest the index providers face and the power they wield over markets, we need a national conversation about how to ensure that they operate with integrity, transparency and accountability. Unfortunately, existing law is ill suited for the purpose.

That’s why we’re calling on the Securities and Exchange Commission to study this issue and make recommendations, if necessary, to Congress. Lawmakers must take a more active role in overseeing how index providers shape how trillions of Americans’ investment dollars are allocated. We need to bring more transparency and accountability to the way these companies use that influence.

Robert J. Jackson Jr. sits on the Securities and Exchange Commission. Steven Davidoff Solomon is a professor at the University of California, Berkeley, Law School and director of its Center for Law and Business.

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