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Index Funds Aren't All Passive

Ben Johnson, CFA
Christine Benz

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Even if you own an index fund or ETF, that doesn't mean that there's not some active decision-making going on behind the scenes. Joining me to discuss that topic is Ben Johnson. He is director of Morningstar's global ETF research.

Ben, thank you so much for being here.

Ben Johnson: Thanks for having me, Christine.

Benz: Ben, you wrote a recent piece about the evolution of indexes. Let's talk about that because I think index fund investors might not appreciate that indexes didn't start out as something to invest in.

Johnson: That's absolutely right. I think most investors when they think of indexes, they think of a means of measurement, no different really than, say, the metric system. But different from the metric system, whereby once we decided a meter is a meter and a kilogram is a kilogram and will be now and forever, indexes are living, breathing organisms. They continue to grow, they continue to evolve, and over the years they have evolved in very meaningful ways. 

At first, they were designed to be measures to try to give us a sense of where markets are going, where they have been. More recently, they have evolved into being targets. They are the underpinnings of investable funds, most notably with the launch of the first retail index mutual fund in the mid-1970s by Jack Bogle and Vanguard.

Fast forward to today, and the latest stage of their evolution has been marked by kind of a metamorphoses into, in many cases, a form of active management. Indexes have become in many instances exactly what they were originally designed to measure. These newer forms of indexes fit into the bucket that we've defined as strategic beta, what others will call smart beta or factor indexes. Indexes, I think, far from being just simple measures, have become subsequently targets and now active management in many cases.

Benz: Let's talk about how even very vanilla products actually have some active decision-making going on behind the scenes. I think the S&P 500 is a great example of that. Let's talk about how some discretion factors into how that index gets put together.

Johnson: The S&P 500 is a great example, and it's an exclusive club. There is a small group of individuals who decide who gets into that club when individuals are kicked out of that club. If you look at a recent example. whereby PG&E has been removed from the S&P 500 index, that group of individuals that is part of a committee at S&P Dow Jones indices, decides what's the next that will be voted up into that exclusive club.

Benz: And how do they look at that?

Johnson: They look at a number of different criteria. Obviously, size is important, the quality of the business is important. There are certain, sort of, more concrete measures that they can take into account. But nonetheless, there is going to be an element of discretion that will be involved in deciding which stocks get voted up to replace those as they graduate through that family of benchmarks as others are removed by virtue of bankruptcy or mergers and acquisitions activity, you name it. And it drives that sort of chain reaction, that event, that ultimately the discretion lies with a committee, a group of individuals.

Benz: That's discretion related to the construction of an index itself. But there is also discretion at the provider level, where the provider can choose which index a product tracks. Let's talk about that piece of it.

Johnson: That discretion, which is ultimately what most directly affects investors, it can be exercised, and it resides along a continuum in terms of the level of impact. We've seen index changes in recent years whereby some funds, notably, many Vanguard funds, have gone from standard versions of their target benchmarks to more expansive at the margin versions of those same target benchmarks. Generally speaking, adding small and even microcap stocks into the mix--in some cases, because those funds have grown tremendously in recent years--they need a wider berth and they can afford a wider berth because they have more money to invest in those smaller names without incurring huge amounts of costs, without taking away from what their core objective is, which is to deliver high fidelity tracking of that index.

Benz: The provider wants to track the index as closely as possible, and the way to do that is to maybe bring in some of the smaller names that heretofore not but included?

Johnson: That's right. To build a portfolio that represents the market in its broadest sense for investors. Now, that's one end of the spectrum, and that doesn't really ultimately move the needle a ton for the end investor. Now, at the other end of the continuum are some extreme examples, one of which being an ETF that had, up until fairly recently, been a Latin American real estate ETF that had a lobotomy of sorts and woke up one morning and was a marijuana ETF. So, a wholesale shift in the underlying index, the underlying strategy, you name it …

Benz: And not at all what investors necessarily were bargaining for when they bought the thing in the first place?

Johnson: Not at all what they signed up for in the place. What you see between those two extremes on the continuum are a variety of different shades, a variety of gradients where either they are outright index changes in some cases; in other cases, there might be changes to index methodologies. All of these are important for investors to understand to decide whether or not, in some cases, is this still what I signed up for originally; in other cases, how might this affect the risk, the return profile of the portfolio that I own.

Benz: Some due diligence on an ongoing basis from me as an investor is crucial. How do I stack the deck in my favor to ensure that the discretion to the extent that it's happening is on my side, that these decisions are being made with my best interest at heart, not necessarily with the provider's interest at heart?

Johnson: I think investors can protect themselves, can sleep well at night if they invest in the most broad-based, the most well-diversified, the lowest-cost index products that are out there on the marketplace. Those are the ones similar to the example I described that at the margin are growing ever larger, can expand that opportunity set that they are investing in directly for investors. By virtue of doing that because they have such a large scale are offering those portfolios at the lowest possible costs, in some cases, for next to nothing. If not, after accounting for just good portfolio management in all intents and purposes, for nothing. Those are the ones that I think at the margin are going to continue to evolve and evolve in a way that takes into account their impact on markets and evolve in a way that will be ultimately friendly to investors. Those are the ones that I think investors are best served by today and will be tomorrow and as far as we can see down the road.

Benz: Ben. Always great to get your insights. Thank you so much for being here.

Johnson: Thanks for having me.

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