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How trillion-dollar stock-market index funds are vulnerable to manipulating that 'could harm American investors'



Dangers may lurk in index funds, a popular area of ​​the stock market known for its recent and consistent record of outperformance against actively managed funds, according to experts.

A recent op-ed in the New York Times caution that passive index funds may be vulnerable to bias and, possibly manipulation, as interest in those funds has ballooned over the last decade.

Read: Opinion: Why the 'mania' for index funds will not be breaking the stock market

This is how Robert J. Jackson Jr., a member of the Securities and Exchange Commission, and Steven Davidoff Solomon, a professor at the University of California, Berkeley, Law School, published in February. 1

8 in the New York Times:

But there's a problem: The indexes these funds are based on may not be as neutral as they appear. The firms that develop these indexes face little regulatory scrutiny and can face significant conflicts of interest, which can potentially harm American investors.

For example, MSCI added Chinese emitents to its emerging market index after what the Wall Street Journal said was pressure from the Chinese government. Another conflict is when the index and fund are run by the same managers, which can be the case for highly customized indexes.

Jackson Jr. and Solomon added the article in Times:

Conflicts of interest should worry anyone 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 investor's 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.

By and large, investors in recent years have left actively managed strategies in favor of passive ones in vehicles such as exchange-traded funds or ETFs that track the Dow Jones Industrial Average

                            
                            
                                  
      
      
      
      
      
      
      
      
      
                            
                                     DJIA, + 0.03%

and the S & P 500 index

                            
                            
                                  
      
      
      
      
      
      
      
      
      
                            
                                     SPX, + 0.15%

for example. Those include, passive ETFs like the SPDR Dow Jones Industrial Average ETF Trust

                            
                            
                                  
      
      
      
      
      
      
      
      
      
                            
                                     DIA, + 0.06%

known by its ticker "DIA," and the SPDR S & P 500 ETF Trust

                            
                            
                                  
      
      
      
      
      
      
      
      
      
                            
                                     SPY, + 0.17%

known as "SPY", for example.

Active management was the standard in Wall Street, and it was tremendously popular in the dot-com era, when highflying internet stocks minted star money managers.

Interest and money flows have grown because of both outperformance against their actively traded counterparts, such as hedge funds and mutual funds, and their relatively low costs Such passive ETFs track the index by composition and proportion and are not intended to beat the benchmark but simply reflect its moves. Such a passive investment, as Morningstar has put it, in a report last summer, has "failed to survive and beat their benchmarks, especially over long time horizons," especially when fees and other costs are accounted.

Morningstar says the growth of ETFs have been driven by this massive shift to passive investment, with the likes of Vanguard, founded by John Bogle. and BlackRock

                            
                            
                                  
      
      
      
      
      
      
      
      
      
                            
                                     BLK, -0.20%

                            
                                  
      
      
      
      
      
      
      
      
      
                                  

According to Morningstar, total assets in U.S. mutual funds and ETFs have reached a record just over $ 18 trillion at the end of 2017, a tripling of assets from just $ 5.5 trillion just nine years ago. Nearly $ 6.7 trillion, or a third of those assets resided in passive funds at that time, the data provider said.

To be sure, not everyone agrees with the views shared by Jackson Jr. and Solomon.

"Hard to imagine an investment more transparent than index funds that publish holdings and rule a daily basis. Investors who want to understand what is inside need only do some homework. While we agree that there is less regulatory clarity on what stocks fit the criteria, the index uses there's more than enough info to see the output. "CFRAR Research Director of ETF & Mutual Fund Research Todd Rosenbluth told MarketWatch via email on Tuesday.

Rosenbluth said the examples offered by the authors in the Times op-ed "do not seem to apply … to plain vanilla funds that investors are primarily exposed to."


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