Document Type

Article

Publication Date

2024

Abstract

So-called passive index funds—investment funds that are designed to track a pre-specified underlying index—have become a dominant force in the investing landscape, collectively controlling over $12 trillion in assets. It is widely assumed that these funds are obligated to follow their underlying index, and that fund managers cannot, or do not, select portfolios that deviate from that of the index. As a result, various critics have attacked these funds, including raising concerns about their corporate governance incentives to fears about their influence on market efficiency.

We show that this assumption is overly simplistic both as a matter of law and of empirical fact. To do so, we examine funds that track the most prominent index, the S&P 500. S&P 500 index funds do not typically commit, in a legally enforceable sense, to holding even a representative sample of the underlying index, nor do they commit to replicating the returns of that index. Managers therefore have the legal flexibility to depart substantially from the underlying index’s holdings. We also show that these departures are commonplace: S&P 500 index funds routinely depart from the underlying index by meaningful amounts, in both percentage and dollar terms. 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. Across all S&P 500 funds, these deviations amounted to almost $61.5 billion in discretionary investment decisions. Moreover, at least within observed ranges, we find no meaningful relationship between these deviations and investment inflows and outflows.

In sum, S&P 500 index funds have substantial investment discretion, and they exercise this discretion to an extent not previously recognized. This further complicates the standard narrative around index funds and weakens many of the criticisms traditionally levied against these funds are weakened. At the same time, to the extent that investors—and particularly retail investors—fail to recognize this discretion, our findings suggest that they may not be getting what they expect.

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