How are $ 1 trillion index funds vulnerable to manipulation that could "hurt US investors"?

According to experts, index funds, a popular sector of the stock market known for its recent and consistent outperformance over actively managed funds, are likely to threaten investors.

A recent editorial in the New York Times warns that passive index funds may be vulnerable to bias and, possibly, manipulation, because of the skyrocketing interest in these funds over the course of time. the last decade.

Lily: Opinion: Why index fund mania will not derail the stock market

For example, Robert J. Jackson Jr., a member of the Securities and Exchange Commission, and Steven Davidoff Solomon, a professor at the University of California at Berkeley, wrote in an article in The Times on February 18. New York Times:

But there is a problem: the indices on which these funds are based may not be as neutral as they appear. Companies developing these indices are subject to limited regulatory oversight and may face significant conflicts of interest that may be detrimental to US investors.

For example, MSCI added Chinese issuers to its Emerging Markets Index after what the Wall Street Journal described as pressure from the Chinese government. Another conflict arises when the index and the fund are managed by the same managers, which may be the case for highly customized indices.

Jackson Jr. and Solomon added in the Times:

Conflicts of interest should be of concern to anyone investing in index funds, many of whom are Americans with retirement accounts. Index providers have tremendous power. The decision to include a company in the S & P 500, for example, involves a reallocation of billions of dollars of money from investors. The average company added to the S & P 500 is gaining value; when withdrawn, its stock market price declines as index funds sell their holdings.

On the whole, in recent years, investors have abandoned active management strategies in favor of passive strategies in vehicles such as exchange-traded funds, or ETFs, which track the Dow Jones Industrial Index Average.

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and the S & P 500 index

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for example. These include passive ETFs such as the SPDR Dow Jones Industrial Average Trust SPDR.

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known as "DIA" and the SPDR S & P 500 ETF Trust

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known as "SPY", for example.

Active management was the norm on Wall Street and was extremely popular in the era of e-commerce, when rising Internet shares were associated with star managers. However, as part of the current expansion, the old order has been disrupted by passive vehicles, perhaps forever.

Interest and money flows have increased due to both the outperformance of their actively traded counterparts, such as hedge funds and mutual funds, and their relatively low costs. These passive ETFs track an index by composition and proportion and do not aim to exceed a benchmark but simply reflect its movements. As Morningstar put it, these passive investments last summer have "failed to survive and exceed their benchmarks, especially over the longer term," especially when fees and other costs are accounted for.

Morningstar said the growth in ETFs was due to this massive shift in passive investment, with Vanguard, founded by John Bogle. and BlackRock

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According to Morningstar, total US mutual fund and ETF assets reached a record high of more than $ 18 trillion by the end of 2017, a tripling of assets of 5.5 billions of dollars just nine years ago. Nearly $ 6.7 trillion, or a third of these assets, were in passive funds at that time, the data provider said.

Of course, not everyone agrees with the opinions shared by Jackson Jr. and Solomon.

"It's hard to imagine a more transparent investment than index funds that publish assets and govern daily. Investors who want to understand what is inside need only to do their homework. While we agree that the regulations do not clearly define the actions that fit the criteria, the index uses more information than is necessary to see the result, "Todd Rosenbluth, director of Fund and Mutual Fund Research at CFRA.

Rosenbluth said that the examples proposed by the authors in the Times editorial "do not seem to apply … to plain vanilla funds to which investors are primarily exposed."

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