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How Objective Is Your Index Fund?

Benchmark construction is not as mechanical as you might think.

Christine Benz: Hi, I'm Christine Benz for Morningstar. How much subjectivity goes into creating and maintaining indexes? Joining me to discuss that topic is Ben Johnson. He's Morningstar's global director of ETF research.

Ben, thank you so much for being here.

Ben Johnson: Thanks for having me, Christine.

Benz: So, Ben, this issue has recently come to the fore where people have taken a closer look at indexes and said, wait, these aren't strictly mechanical. There are some subjective decisions being made. Let's talk about that and maybe you can give some examples of ways that indexes have inserted some subjectivity into some of their decision-making.

Johnson: I think a lot of investors are always surprised by just how much subjectivity there is when it comes to developing and maintaining what are nominally passive indexes. And when you think about indexes in their original intent, which was a means of measuring markets' performance, they're really no different than any other form of measurement that we have at our disposal today. I think we take for granted that long, long ago, someone had to decide what an inch was, what a foot was, what a mile was. Similarly, at some point in time, someone, most notably in the case of the U.S., Charles Dow, had to decide what was going to be a good measure of the U.S. stock market, and that goes all the way back now to 1897.

Now, what we've seen in the ensuing century-plus is that indexes have really evolved, and they've always been kind of living, breathing animals. They've evolved most notably to reflect the evolution in our economy. The stocks that make them up have all changed; the businesses that those companies are involved in have all changed, have all continued to evolve. And this has come to the fore really this year because we've seen a number of notable instances where this degree of subjectivity has really made headlines. Earlier this year, notably, a number of major index providers decided to actually postpone their regularly scheduled rebalances, which is something that investors have come to expect to happen like clockwork. Now, this was made in light of the extreme volatility that we saw. It was done in an effort to really protect investors--in some cases, for index fund investors and ETF investors--from having to trade in an environment where it was very costly to do so.

We've seen other more recent examples, I think, notably some headline changes in the Dow, where you saw one constituent, Exxon Mobil, that had been part of that index for nearly 100 years, get kicked out, and you saw more sort of recent additions. notably is a new add. So, indexes are a measure of what's going on in the market around us. Again, they're living, breathing creatures, will continue to evolve. They have to, I think, continue to evolve, too, to reflect investors' opportunity set and how that's evolved. Within emerging markets, for example, in recent years we've begun to see major benchmark providers include more constituents from the onshore Chinese equity market, Chinese A-shares, which was an opportunity set that for many global investors had either been off limits or only accessible through other means that were often the exclusive domain of institutional investors. Now, an investor in the U.S. in a broadly diversified emerging-markets ETF gets access to Chinese A-shares, which had formerly been the exclusive domain of very large institutional investors. So, it's just another example of how indexes will and have continued to evolve over time.

Benz: As an investor in exchange-traded funds or index funds, what do I need to know about how a fund goes about or how an index goes about making these decisions on my behalf?

Johnson: Well, it really varies on an index manufacturer by index manufacturer basis. In some cases, there are very clear rules that dictate the composition of the index. In other cases, there's a degree of subjectivity. Certainly, that is the case in the example of the S&P Dow Jones Indices family of benchmarks whereby a committee has ultimate say over the composition of those benchmarks, additions and deletions.

Now, I think it's important to put this in perspective too, that in virtually all cases these are very broad benchmarks. These decisions, while they may seem very meaningful at the time--so the decision whether to add or not to add Tesla to the S&P 500, for instance, makes for interesting headlines, but over a long period of time really is going to be a blip in one direction or another from the point of view of an investor who might be investing in an index mutual fund or ETF that's underpinned by the S&P 500.

I think it's also important to understand that at the margin there are costs involved in changing the composition of a benchmark. And what we've seen recently is many of these index manufacturers, as more and more investors have sort of gravitated toward indexing as index funds globally have gotten ever bigger, have tried to lessen their footprint on the market when it comes to implementing their trades. So, notably, in the case of the Vanguard Total Stock Market Index Fund, which now has nearly $1 trillion in assets under management, that underlying index underwent a change whereby it went from rebalancing all in one day to rebalancing over a five-day period, again to lighten its footprint on the markets as the heft of money that is ultimately trying to follow that index has gotten greater and greater over time.

From an investor's point of view, again, I think most of this in the grand scheme of things is interesting fodder for headlines but going to be a blip in terms of your outcomes. And for those looking to select among different index funds, what I would say is that the broader the index, the less sort of seams there are in that index. So, I'm referring to total stock and total bond market indexes. The less this blip becomes a blip at all, it may not even register on your radar. It may have no effect on your long-term outcomes.

Benz: Ben, really helpful discussion. Thank you so much for being here today.

Johnson: Of course. Thanks for having me.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.

Ben Johnson does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.