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Index investing: Not as passive as you might think

Adriana Robertson, assistant professor in the University of Toronto law faculty

Index investing isn't really passive, according to a University of Toronto faculty member.

"Rather than being passive in any meaningful sense, index investing simply represents a form of delegated management," wrote Adriana Robertson, assistant professor in the University of Toronto law faculty, in a paper, "Passive in Name Only: Delegated Management and 'Index' Investing," issued in November. The paper has been accepted for publication by the Yale Journal on Regulation, published by the Yale Law School, and is likely to be published in mid-2019, she said.

"Instead of being truly passive, tracking an index almost always implies choosing a managed portfolio," Ms. Robertson wrote. "Not only are these indexes managed portfolios in the strictly financial sense, by their construction they imply a substantial amount of delegated decision-making authority."

Is Ms. Robertson arguing that index investing is no different from active management? "The answer is obvious if you think about it," she said in an interview. "We have this idea in the back of our minds that indexes are passive because they're divorced from active management decision-making. But like active management, indexes are just the result of decisions by people."

While the paper doesn't focus on institutional investing, Ms. Robertson said the decisions made by index providers to determine how the indexes are constructed, "should be a concern for all investors, including institutional investors."

The paper reviewed more than 900 indexes, including 603 that are used as benchmarks for 3,208 mutual funds, she said.

In the paper, Ms. Robertson also argued that passive mutual funds and exchange-traded funds often follow indexes that were created for those funds. "The idea that an ETF might follow an index that it creates is counterintuitive and, to my knowledge, is not something that has been previously documented," Ms. Robertson wrote. However, the paper does not detail the impact of index creation for ETFs on expense ratios, although "digging deeper into this phenomenon is something that I intend to pursue in further work," Ms. Robertson said.

The data on fees comes from the CRSP Survivor-Bias-Free US Mutual Fund Database. There are ETFs based on CRSP indexes.

As a general matter, some indexes are created to be tracked by certain funds, Ms. Robertson said in the interview. "Someone will ask for a custom index to track. Other indexes, like the S&P 500, are used for lots and lots of things — mutual funds and ETFs, but also options, futures, other derivatives." However, the paper's premise extends to broader indexes like the Standard & Poor's 500 stock index, Ms. Robertson added.

One of the chief issues in Ms. Robertson's paper is that there's no disclosure on who ultimately is making the decisions on index composition.

"There's not a lot of regulation, there's no required disclosure of who the decision-makers are in index creation and composition, like there would be with decision-makers in a publicly traded company," Ms. Robertson said. "It looks like there are a lot of index funds out there that are following indexes that are not nearly as prominent as the S&P 500. These funds sometimes disclose that a third party created the index with the input of fund managers. But you can't see who actually is deciding what the index will be composed of."

Ms. Robertson thinks that lack of information is "something I think people should be aware of. One way to think about it: If I buy an active mutual fund, the fund manager makes the decisions (on investments). But whoever is making the index is making the decisions on what's in them. The only difference between them is who is making the decision."

However, Ms. Robertson doesn't think the solution is to require index providers to disclose how benchmarks are created. "I don't think we want regulators directly regulating indexes," she said. "There are so many indexes that are used for so many different things. I don't think we want to regulate that whole area on account of one particular use case — mutual funds and ETFs. I think we just need to be aware that you need to know how indexes are composed and who is composing them. As I discuss in the paper, I think that the most appropriate means of regulation is via the regulation of the funds that use the indexes, not the indexes themselves."

David Lafferty, senior vice president and chief market strategist at Natixis Investment Managers, Boston, and chairman of the research task force on the Investment Advisers Association's Active Managers Council, agreed with the paper's premise, saying that thinking of index funds as purely passive is a "mistake."

"Investors tend to see the differences between active and passive as very black and white," Mr. Lafferty said. "Their intuition is that when you buy a passive fund, you're buying the market. However, this misses a key point that passive strategies are derived from indexes, and the creation of those indexes is a very active process. Investors are not simply buying the market, they are effectively buying how the index provider defines that particular market."

Those decisions, Mr. Lafferty said, include "which securities to include, how they are removed, and how frequently the index is rebalanced. The active decision about which securities to include can be further broken down into decisions on size, liquidity, quality or myriad other factors. These active construction rules can have an enormous impact on the return profile of a passive strategy, especially those that are focused on more niche areas, like smart beta or factor-based indexes."

However, Rolf Agather, Seattle-based managing director of North American research at index provider FTSE Russell, said it's important to keep in mind the ultimate goal of an index.

"You could categorize many of the decisions we make as active, and note that many of the indexes being created nowadays are more active in the sense that they differ from a broad cap-weighted benchmark," Mr. Agather said. "But it is important to note that the objective of these decisions is quite distinct from a traditional active strategy in that the goal of the index is to provide exposure to a particular market segment, whereas in a traditional active strategy the objective is to determine relative value of individual securities or market segments. The goal of the index is representation, not outperformance."

Also, ETFs have "full transparency available to anyone through the methodologies in regards to their holdings," said Darek Wojnar, executive vice president and head of funds and managed accounts at Northern Trust Asset Management, Chicago. "Some index providers have their own policies for disclosures, but ETFs disclose holdings on a daily basis," Mr. Wojnar said. "You could take a look at any ticker any day and find out the holdings. That's not always the case with active portfolios, which may provide that information weekly or quarterly."