In an editorial published this week in The New York Times, a commissioner with the Securities and Exchange Commission and a professor at the University of California advocate for more transparency and accountability in the role of index providers.
While pointing out that trillions of Americans’ investment dollars track index investments, they muse that there are significant conflicts of interest and little regulatory scrutiny tied to these indices. CFRA agrees that what’s inside the index behind an ETF or mutual fund is not obvious without doing some homework.
The three largest U.S.-listed ETFs—SPDR S&P 500 ETF (SPY), iShares Core S&P 500 ETF (IVV) and Vanguard S&P 500 ETF (VOO) —track the prominent S&P 500 index run by S&P Global as do more than 100 mutual fund share classes. Price competition is so intense in the index fund world that the Schwab S&P 500 Index Fund (SWPPX) charges a tiny 0.02% expense ratio.
Index Methodology Matters
The editorial authors remind readers that the “500” is chosen by a committee without providing much justification for their concern of the “power they wield over markets.” The op-ed article also expresses concern about “the rise of highly customized indexes, which are developed for the use of a single fund.”
Indeed, there are dozens of smaller ETFs that track slices of the S&P 500 based on a distinct set of rules that focus on unique fundamental or trading patterns. While the indexes behind these ETFs have a history that can be scrutinized, we think most investors never thought about such an index until they learned of the ETF.
For example, Invesco S&P 500 ex-Rate Sensitive Low Volatility (XRLV) tracks an index that screens for stocks with low volatility characteristics only after removing stocks that performed poorly in prior rising interest rate environments. Our research highlights XRLV has less utilities exposure than many other low-vol strategies.
Meanwhile, AAM S&P 500 High Dividend Value ETF (SPDV) tracks an index of companies with an above-average dividend yield and strong free cash flow generation, in an attempt to avoid value traps. Some of SPDV’s largest holdings include utilities, such as AES and Centerpoint Energy.
Yet, in an increasingly competitive index-based fund world, asset managers have looked to bring down the price of their existing or newly launched funds. To do so, they have often leveraged their broader in-house resources by tracking a proprietary index.
Fidelity High Dividend ETF (FDVV) tracks the aptly named Fidelity High Dividend Index, a custom multi-cap index of companies with high dividend yields that are expected by Fidelity to continue to pay and increase the dividend. Compared to many other dividend ETFs, FDVV has a healthy weighting to information technology stocks, with Apple and Microsoft among its top positions.
Another example of a firm using its in-house resources to develop a unique index is SSGA. While the firm still offers SPY for 0.09%, the asset manager changed the name and the index behind SPDR Portfolio Large Cap ETF (SPLG) in late 2017 as part of its low-cost rebooting of its asset allocation lineup.
Tools For Investors Exist
Instead of tracking the Russell 1000 index as it originally did, SPLG tracks a proprietary market-cap weighted index of approximately 760 large-cap U.S. stocks and now charges a modest 0.03% expense ratio, down from 0.10% in the past. By bringing the index efforts in house, CFRA believes SSGA was able to pass along the savings to its ETF shareholders.
The NY Times editorial points out that index providers generally have wide leeway when choosing individual companies that make up their indexes and how they are weighted.
CFRA agrees, but we remind readers that there are index methodology documents available for review and the daily transparency of holdings. Moreover, third-party tools, such as those offered by CFRA and ETF.com, make it easy for investors to understand what they are and are not holding—as well as why.
To bolster their point that more scrutiny is needed, the op-ed authors reference the Libor-rigging scandal in 2012 when the Justice Department revealed that influential banks had manipulated the lending rate benchmark for excess profits.
Yet, CFRA thinks the asset managers and index providers behind popular funds—often operating within the same firm—are transparently providing a rule book that is being utilized to offer lower-cost investment alternatives than more expensive and more opaque mutual funds.
We think the investment community just needs to better utilize the tools the asset management community offers them to better understand these index ETFs and mutual funds.
This article originally published on MarketScope Advisor on February 20, 2019. Visit https://newpublic.cfraresearch.com/ to learn more.