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A blog on financial markets and their regulation
(This was posted on my blog yesterday but due to an oversight was not copied to mirror sites until now.)
Adriana Robertson argues in a recent paper that index investing is not passive investing; it only delegates the active management to the index proviver. (Passive in Name Only: Delegated Management and ‘Index’ Investing (November 2018). Yale Journal on Regulation, Forthcoming. Available at SSRN). This is a problem because mutual funds are regulated, but index providers are not. The paper presents data showing that the vast majority of indices in the United States are used as a benchmark by only 1 or 2 mutual funds, and so it is hard to argue that these index providers are subject to strong market discipline.
She offers an ingenuous suggestion to solve this problem without new intrusive regulation.
While a mutual fund cannot deviate from its fundamental policies, as stated in its registration statement, without a shareholder vote, there is no restriction on an index’s ability to change its methodology.
Fortunately, there is a simple solution to this problem. Once we recognize that delegating to an index is no different from delegating to a fund manager, we can craft a solution based on the existing rules: Any time the underlying index makes a change that, if made by the fund manager in a comparable actively managed fund, would trigger a vote, the fund manager is required to hold a vote on retaining the index. This simple change would harmonize the protections offered to investors in the two types of funds.
I can think of at least two significant index changes that would qualify under this rule, and on both these, I think Adriana Robertson’s solution makes eminent sense: