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Rekenthaler Report

The Heat Grows on Indexing

Additional regulations seem inevitable.

Chastised Again
On Monday, The New York Times continued its periodic critiques of investment indexing, with "What's Really in Your Index Fund?" This follows two reproachful Op-Ed articles about indexing in 2016 and then another last year.

Steven Davidoff Solomon, a law professor at UC Berkeley, penned the first of these missives and was joined on Monday by Robert Jackson Jr., one of five commissioners at the SEC. As Jackson was appointed to his position by President Trump, and the driving force behind the Times' other articles, Eric Posner, generally espouses leftist views (although he describes himself as a centrist), the criticisms of indexing are bipartisan.

The concerns of Solomon and Jackson differ from Posner's. The latter postulates that index funds are lax shareholders, thereby permitting corporations to engage in a soft form of collusion. They keep their prices unnaturally high because their stockholders aren't pushing them to grow market share. Solomon and Jackson, meanwhile, worry about index providers rather than the actions of index funds.

(Now is the time to mention that Morningstar (MORN) is one of those index providers. However, as the business is but a small fraction of Morningstar's revenues, and it does not involve me, I believe that I can comment on this subject dispassionately.)

Badgers and Bullies
Solomon and Jackson's central claim is that index providers "can face significant conflicts of interest" when constructing their products. As an illustration, they cite Morgan Stanley Capital International's recent decision to add Chinese stocks to its MSCI Emerging Markets Index. According to The Wall Street Journal, China threatened "business blackmail" unless MSCI acquiesced to China's request demand.

That is a powerful example. If the allegation is true, it suggests that wealthy, powerful interests can badger their way onto indexes in which they don't belong. (China clearly is an emerging market, in fact the emerging market, but its mainland-based companies may not offer enough transparency--and corporate governance--to warrant placement on MSCI's index.) That would not only be bad public policy but also would likely harm index funds' investment results.

The authors provide a second instance, the Libor-rigging scandal. In 2012, it was revealed that, for many years, several member banks had manipulated the interest rates that they submitted for the construction of the London Interbank Offered Rate Index, which establishes banks' borrowing costs. As Libor is a widely used global benchmark, this example would seem to solidify the authors' claims.

I am not sold. While Libor is indisputably an index, it is a different animal than the indexes that underlie mutual funds (and exchange-traded funds). Libor is an index created from survey data, akin to, say, Michigan's Consumer Sentiment indicator. In contrast, retail index funds predominantly (as measured by number of funds) or almost entirely (as measured by assets) invest in indexes that hold securities. In such cases, the Libor-rigging scandal is immaterial, because nobody has the power to fudge, say, the prices of the Wilshire 5000's members.

In other words, the authors cite one outstanding example but have difficulty identifying a second. Perhaps Jackson, in his SEC role, knows of problems that he has decided not to divulge. That would strengthen the authors' case. As it is, though, their public argument that indexes have been manipulated is based almost solely on general suspicions.

Built In-House
A related problem, believe Solomon and Jackson, are customized indexes--what Morningstar terms "self-indexing." Typically occurring with ETFs, self-indexing happens when funds eschew off-the-shelf indexes and instead base their portfolios around an index that was built solely for their use. In such instances, the authors point out, "the index and the fund are frequently run by the same managers."

They regard that as a dangerous situation, writing, "Indexes like these start to look less like the objective benchmarks investors often believe they're getting. Investors may not understand how the index works or whether it may be susceptible to undue influence." I do not follow. I understand their first point, that customized indexes may cause investor confusion, but I do not see how self-indexing increases outsiders' influence.

In summary, index corruption seems at this stage to be more theoretical than actual. 

The Feds Are Coming
But I do not wish to shrug off Solomon and Jackson's comments. Although I am unconvinced that index providers have yet been meaningfully compromised, that event certainly could happen. And the likelihood will grow rather than shrink. Indexes become more important each year, as passively managed funds continue to increase their market share. The amount of assets that they control may tempt the innocent to sin. That is, those who run companies with stocks that are outside of indexes may push harder for inclusion--perhaps too hard.

As a result, I support the authors' call for greater scrutiny. They request that the SEC study how index providers operate to see if Congress should enact legislation that would strengthen transparency and accountability. As they state, investment managers are scrutinized much more intently than are index providers. That regulatory gap need not close completely, but it should narrow.

Plus, there's no fighting the ocean. In one of his last appearances, in June 2018, Jack Bogle said, "There's no way that the federal government will stand by while a handful of fund companies gain control of 40% of the U.S. stock market." At the least, the U.S. government will study and strengthen regulations. At the most, it will disband the giants. The former is the preferable solution. Best to support it, rather than resist and face the possibility of the latter.


John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.

John Rekenthaler has a position in the following securities mentioned above: MORN. Find out about Morningstar’s editorial policies.