Are Index Funds Passive Aggressive?

“The index provider is becoming more of a stock picker,” said Rodney Comegys, head of investments for Asia Pacific at Vanguard Group (which oversees more than $3 trillion in primarily passive funds). “In some ways,” he says, “they’re replacing the active manager.” In a article from earlier this month, Bloomberg’s Andrea Tan delved into the surging presence of index funds.

The article characterizes New York-based index compiler MSCI and others (including FTSE Russell and S&P Dow Jones) as becoming “the most important arbiters of where the world’s stock investment flows.” The power of these indices is underscored by the fact that, earlier this month, Chinese authorities lobbied (albeit unsuccessfully) to gain entry into MSCI’s stock inventory. “They have an awful lot of power,” says George Cooper, chief investment officer at Equitile Investments Ltd. in London.

Tan differentiates index providers from active managers, who choose stocks in an attempt to “beat the market.” The criteria used by indices such as MSCI are “measures of investability, such as market capitalization and daily volume, rather than anything purporting to generate above-average performance.” That said, Tan stipulates that there is some subjectivity involved in creating a benchmark index, especially on issues around which countries to include and how to categorize them (i.e. developed, emerging or frontier). Further, the article refutes the notion that index firm clients give carte blanche. Mark Makepeace, London-based chief executive officer of FTSE Russell says, “International investors will not blindly follow any decision we make.”

The rise of smart beta (an investing style that utilizes factors other than market capitalization) adds yet another cog in the wheel of growth for index providers. According to BlackRock, the world’s largest money manager, assets in smart-beta ETFs will probably climb to $1 trillion by 2020 (from $282 billion at the end of March).

But the rise of index investing doesn’t come without concerns. Cooper says the trend could lead to market distortions where funds will “move into or out of shares because of their status in key indexes, instead of anything to do with the securities’ underlying value.”