Most of us are index investors. By investing this way, we heavily rely on correct indeces, created by index providers such as MSCI, FTSE, S&P etc. What do you think are the risks of collusion between index providers and ETF providers for retail investors?
Also: Are index providers allowed to hold stocks and might therefore benefit from the inclusion/exclusion of stocks in their indeces?
Well, nothing to worry about it seems, fine by me 
What do you think those risks are?
(Also title is inaccurate/click baity, most of the article is about maybe thinking sometimes having a few more regulations for index providers by asking the public for comments, that doesn’t seem like anything super pressing)
Well, we are under the impression that we buy market-weighted ETFs from Vanguard, Blackrock etc. Why do we believe that? Because a totally independent scientifically working index provider offers the framework. Problem is: MSCI, FTSE etc. are not charitable organisations, but for profit, prone to insider trading, fraud, collusion etc. just as any other company in the world. So who controls index providers? Who ensures that certain stocks are not deliberately over- or underweighted within indexes, perhaps in collusion with ETF providers, and that these differences cannot be used to the detriment of retail investors? Looking at the success of the ETF industry, even the tiniest irregularities could lead to massive illegal profits.
My impression is that some people idealize the ETF industry (including index providers) as saviors of the small retail investor, leading them to not be critical enough. For example, Vanguard seems to have an almost saintly image, despite being a for-profit company like any other.
So, if index investing’s supposed to be the new holy grail, why not take a closer look at its players? The same players you’ll find anywhere else in the industry: profit-hungry guys, for the better and the worse. In the past, it’s always been the small ever too naive investors being ripped off.
How would that work?
Not exactly true. Once you buy an american ETF-share (not an european, it is not allowed), you also become automatically owner of that fund. It is more a cooperative in this sense, where profits would go to the owners (in this instance the shareholders of the funds). But actually Vanguard choses to lower the costs as soon as they can.
Furthermore, everything is public. You can check the composition of the fund etc. online, not sure how someone would be able to cheat. Especially knowing that at the slightest unexplainable tracking error, the risk department of the institutional investors will get nervous and might move away.
The only potential issue I’m aware of is that, because the rule book is public, people can determine future index changes before funds implement them. This may allow some market participants to benefit as they know that the index funds are forced to buy or sell a large number of shares of newly added/removed stocks, no matter the price.
I don’t know how big the effect of this is in practice. Probably not a big concern to the average index investor. My assumption is that (nearly) total market stock funds such as VT or VTI will be less affected by this than funds tracking a limited index as I expect less significant index changes in the former.
Andres Vinelli, vice president for economic policy at CAP and the former chief economist at the Financial Industry Regulatory Authority, pointed to new research that indicates index providers could be adjusting their inclusion criteria to benefit issuers with which they have a financial relationship.
In November, academics Kun Li and Xin Liu of Australian National University and Shang-Jin Wei of Columbia University published researchwhich argued that S&P Global’s index division has significant discretion over which firms ultimately end up in the S&P 500 and that “the discretion is often exercised in a way that encourages firms to buy fee-based services from the S&P.”
“This happens to issuers that are companies, but could happen with whole countries,” Vinelli said in an interview. “If you’re managing a bond fund, countries might want to have their bonds in your fund and there might be levers countries can use to induce you to do that.”
Source: marketwatch.com
It’s no secret that the S&P500 is managed by committee on a discretionary basis. Criteria are - among others - market cap, profits history and available float. Although those criteria are a guide, they are no guarantee of inclusion in the index. And SPGI is quite open about it, and this has been the case since the index creation in 1957.
So yes, the S&P500 is an “active” index. With 500 companies in it, but still managed discretionarily. And one that has performed quite well over time, when we see how hard it is to beat.
And frankly, I don’t see any issue with that. I see more an issue with big asset managements creating mutual funds and ETFs on the S&P500, branding them “passive”, and retail investors believing that lock, stock and barrel without asking any question.
SPGI, MSCI and FTSE provide thousands of indices, some of them systematic, other discretionary. It’s up to asset managers to choose the most relevant ones.
PS: looking at history, even if the SEC investigates, I can tell you what will happen: absolutely nothing. Back in 08 when the same kind of companies (SPGI and Moody’s) were selling toxic AAA bond ratings, nothing happened. A bit of scandal for a year or two, but since then those business thrive. Bond ratings are the gold standard for measuring credit risk, in the same way that indices are the gold standard for measuring performance.
If putting AAA bond ratings on toxic assets did not kill those companies, I can tell you that nothing will. Even if there is a major scandal in index construction, it won’t change anything to the industry. These businesses are indestructible.
One word:
ESG criteria.
Are there unbiased rulebooks that allow for fair and objective comparison between companies, even across different industries?
Just to make it clear: I’m not trying to throw dirt around. I just find it hard to believe that some guys here say they invest major parts of their total net worth without actually asking though questions about where their money goes, how it’s being used, or critically observing the industry. Do you honestly believe Vanguard, FTSE, Blackrock or MSCI care about you or your financial wellbeing? That they’re “democratizing finance”? Nope, they’re in it for the profits, prone to misbehavior, and therefore need oversight (including the public eye and critical customers) like every other player in the financial industry.