(This article first appeared as Beyond Liquidity on Markets Media. Beyond Liquidity is produced in collaboration with Liquidnet.)
Managers of S&P 500 index funds have substantial investment discretion, and exercise this discretion to an extent that has not been previously recognised, according to preliminary academic research.
Passive index funds are designed to track an index and provide investors with access to a broadly diversified portfolio at a low cost. Index funds’ share of the U.S. stock market doubled from 8% to 16% between 2011 and 2021.
They have become a dominant force in fund management, collectively controlling over $12.6 trillion in assets, or 43% of total mutual fund market, in 2022 according to a paper from Peter Molk, John H. and Mary Lou Dasburg Professor of Law at the University of Florida Levin College of Law and Adriana Robertson, the Donald N. Pritzker Professor of Business Law at the University of Chicago Law School.
Their paper, Discretionary Investing by ‘Passive’ S&P 500 Funds, said asset managers have legal flexibility to substantially shift from the underlying index’s holdings and that departures are substantial, in both percentage and dollar terms.
“These deviations represent direct evidence against the widely held assumption that index funds, and especially the funds that track a major index like the S&P 500, lack investment discretion,” said the paper.
Molk and Robertson analysed funds that track the most prominent index, the S&P 500, as they represent one quarter of US equity index funds and 40% of assets under management. They manually identified 78 S&P 500 index funds between January 2015 and December 2022, including both ETFs and open-ended mutual funds, which represented 223 fund classes, and constructed the fund’s active share at the end of each quarter.
The paper said 98.9% of the funds have active shares below the 20% mark. Collectively, the deviations comprised almost $61.5bn in investor funds in the fourth quarter of last year.
“While these departures are largest among smaller funds, they are also present among mega-funds: even among the largest S&P 500 funds, holdings differ from the index by a total of between 1.7% and 7.5% in the fourth quarter of 2022,” said the paper. “Across all S&P 500 funds, these deviations amounted to almost $61.5bn in discretionary investment decisions.”
They also found no meaningful relationship between these deviations and investment inflows and outflows. Molk and Robertson stressed that their empirical findings are based on funds that track just one index over eight years under equilibrium conditions, so may not be representative of all time periods or of funds that track other indices, particularly specialised indices that are created specifically for the fund that tracks them. In addition, their analysis is based on four days per year as that index funds are required to disclose their holdings on a quarterly basis.
“We also do not interpret our results as suggesting that S&P 500 funds could deviate from the index more than they currently do without adverse reactions from their investors,” they added.
They concluded that neither law nor private contracts requires index funds to hold the same companies, in the same concentrations, as the indices they track and they found systematic deviations which represent billions of dollars per quarter in aggregate.
“Even quintessentially passive index funds have, and exercise, investing discretion that can lead one fund’s holdings to differ markedly from another’s,” said the paper. “This insight upends the traditional wisdom that all index funds tracking the same index hold the same companies. As a result, we raise several new implications for law and policy.”
