Updated with correction
The indexing hype cycle took a step up in the last month with two headline-grabbing pronouncements.
Investor Michael Burry of "The Big Short" fame declared a "bubble in passive investing" to Bloomberg News. Then, as if on cue, Morningstar Inc. released data indicating that U.S. equity index mutual funds had finally surpassed active funds in assets.
Though nice fodder for business gossip, such declarations are simply on trend. But mostly overlooked in the midsummer malaise was a far more interesting incident that raised several legitimate questions and concerns involving indexing and exchange-traded funds.
On Aug. 12, Vanguard Group notified clients via email that over a six-week period (June 21-Aug. 5) two environmental, social and governance ETFs — the Vanguard ESG U.S. Stock ETF and the Vanguard ESG International Stock ETF — held securities that should have been screened out by benchmark index provider FTSE Russell, according to Vanguard's letter.
The holdings included gun manufacturers and casino businesses, as well companies whose boards lacked diversity, and comprised less than 0.4% of the U.S. ETF exposure and about 1% of the international ETF exposure.
While holding the securities was deemed to have "had no material impact on the performance of the funds," the issue spotlights the potential for oversight and control breakdowns in indexed products, as well as the expectation and obligations of the index provider.
A Vanguard spokeswoman said the firm is augmenting existing controls, specifically when a change is made to a benchmark, and expecting "justification for each inclusion, which we will then review independently."
A statement from FTSE Russell said the "inadvertent" securities were identified as part of routine checks. "Once identified, the issue was rectified and clients informed of the constituent changes."
The particularly sensitive nature of ESG investing in this instance compounded the situation, but this type of misstep could happen for any index, indexed product or even a separately managed account. When active managers moved away from their mandate for a handful of securities, it was often identifiable and deemed "style creep." But in a quantitative factor or thematic index fund, outliers may not be as easy to spot as in an ESG-focused fund.
In the index world, the potential for errors and omissions — and their root causes — are something of a third-rail topic. The giants of the index industry run so large, and at such low costs, that their model is dependent upon all aspects of their value chain operating as expected.
For example, the agreements between index providers and asset managers are not a matter of public record. What is the responsibility of the index provider if it mishandles a reconstitution? How does it test the veracity of its own data, as well as that of third parties? If there was a material impact to the fund, how would that be handled or disclosed?
In recent years, the U.S. Securities and Exchange Commission, the U.K.'s Financial Conduct Authority and the International Organization of Securities Commissions, among others, have taken up the question of index providers' role, the potential for imposing a fiduciary duty, and greater clarification of in-house indexes at asset managers.
"The relationship with the index provider is just like other third-party relationships," said Adam Teufel, partner at law firm Dechert LLP in Washington.
"Fund managers are focused on how best to track the index, not necessarily to double-check the index provider or index compliance," he said.
Fund managers, however, do have a certain amount of wiggle room, particularly if the prospectus allows for sampling or smoothing transitions in advance of an index change. For ETFs, with transparent holdings and daily creation baskets shared with market-makers and authorized participants, there are numerous entities that could potentially spot abnormal securities — but only investors, the fund adviser and the fund board would have an incentive to rectify an error.
"Others are looking at aggregate statistics and performance, not necessarily names and sectors," said Denise Krisko, president and co-founder of money management subadviser Vident Investment Advisory in Morristown, N.J., and former head of equity index management for BNY Mellon Investment Management. "The adviser is looking at corporate actions, liquidity and deletions as opposed to scrubbing the index strategy or looking over a couple hundred securities."
For example, during the period with improper holdings, the Vanguard ESG U.S. Stock ETF saw $103 million in inflows, while the international ESG ETF took in $70 million, according to ETF.com.