Passive in Name Only: Delegated Management and “Index” Investing

Adriana Robertson is assistant professor at the University of Toronto Faculty of Law. This post is based on her recent article, forthcoming in the Yale Journal on Regulation. Related research from the Program on Corporate Governance includes The Agency Problems of Institutional Investors by Lucian Bebchuk, Alma Cohen, and Scott Hirst (discussed on the Forum here); and Index Funds and the Future of Corporate Governance: Theory, Evidence, and Policy by Lucian Bebchuk and Scott Hirst (discussed on the forum here).

Stock market indices are central to the modern financial system. They are used for everything from benchmarking fund performance, to compensating executives, to evaluating the general state of the market. In recent years, the rise of index—or “passive”—investing has only added to their importance.

Despite this importance, indices have received very little attention. With a few exceptions, most scholars—and even market participants—do not think too hard about where the indices actually come from. Instead, they are generally treated as passive entities, which simply are. Obviously this can’t really be true: indices do not fall from the sky. Instead, they are the product of a series of decisions made by some person or persons. But the nature and scope of these decisions has so far been overlooked.

In a forthcoming article, I provide the first detailed empirical analysis of the landscape of domestic equity indices.

To do so, I hand collected the methodology documents associated with every index that was either used as a benchmark by a U.S. mutual fund or ETF or was being tracked by an index fund or ETF. In total, I examined 601 different indices, representing about 3,200 mutual funds, and almost $10 trillion in investor capital.

These 601 indices ran the gamut. In addition to the usual suspects—the S&P 500, the Russell 2000, and so on—there were a tremendous number of indices that were being used by only a single mutual fund or ETF. In fact, over seventy-five percent of indices I looked at were used as the primary benchmark by only a single fund. Among index funds, this was even more extreme: 459 of the 555 indices being tracked by index funds (almost 83%) were being tracked by a single fund. Not only is there a large number of these indices, there is also a tremendous amount of diversity across indices: everything from fairly vanilla large cap indices like the Russell 1000 to the more exotic, like the SSGA Gender Diversity Index, the Solactive Activist Guru Investor Index, or the WeatherStorm Forensic Account Long-Short Index. Even across indices that purport to have similar aims, I found a high degree of heterogeneity. For example, different “growth” indices often capture “growth” in very different ways

Layered on top of this is the fact that, far from being mechanical and transparent, these methodologies were often vague, and often relied on information or methods that were non-public or even proprietary. The methodologies also change frequently, meaning that one cannot simply investigate an index’s construction once and expect it to stay that way. Finally, far from being mechanical, many index methodologies, including some of the most prominent ones, explicitly grant some group of individuals discretion to make decisions about the index’s construction. The upshot of all of this is that it is generally impossible to reliably recreate these indices based on publicly available information.

In a separate section of the paper, I also explore a related phenomenon of “passive” ETFs that track an index that they, or an affiliate, creates. While they are, strictly speaking, index funds, their existence shows how far we have come from the traditional concept of an index fund as something intended to track “the market.” I also find suggestive evidence consistent with the idea that the funds in question are doing so in order to take advantage of the popularity of “passive” funds, and may be passing costs along to investors in the form of higher expense ratios.

My analysis has important implications for how we should think about the use of indices by mutual funds. First, the term “passive” investing is a misnomer: Far from being “passive,” my findings indicate that index investing is better understood as a form of delegated management, where the delegee is the index creator rather than the fund manager. The difference, however, is that while the SEC regulates mutual funds and investment advisors, indices are, at present, completely unregulated. In the article, I offer some modest proposals that, if adopted by the SEC, would go some way towards closing this loophole while at the same time minimizing any disruptions in the financial markets.

My analysis also has implications for the use of indices as benchmarks. Just as a matter of logic, any comparison between A and B is as much about B as it is about A. The lack of transparency in index creation, coupled with the heterogeneity across indices—including across indices that are supposed to be capturing the same or similar factors—that I document in the paper should cause us to rethink the SEC’s current benchmark disclosure requirements. If an investor doesn’t understand the benchmark and has no meaningful way of finding out what it means, any comparison she makes between an investment opportunity and that benchmark is, at best, meaningless, and at worst, misleading.

Of course, there is nothing inherently wrong with delegated management, and the form of delegated management implied by investing in an “index fund” may also be better—from the perspective of the investor—than other forms of delegated management, such as that of an actively managed mutual fund. My point is not that there is anything wrong with the delegated management implied by an index fund, only that it is still delegated management and should be recognized as such.

The complete article is available for download here.

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One Comment

  1. Funds Attorney
    Posted Tuesday, May 14, 2019 at 11:51 am | Permalink

    The SEC understands that index funds effectively delegate investment decisions to the index providers and has been regulating index funds accordingly for years. See, e.g., https://www.sec.gov/rules/proposed/2018/33-10515.pdf at page 24 (discussing lack of regulatory distinction between actively managed funds and index funds). This article does not grapple with the rules already governing index funds, so it is difficult to understand whether it goes beyond a descriptive analysis.

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