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Discretionary Investing by ‘Passive’ S&P 500 Funds
Molk, Peter Robertson, Adriana Z.
Molk, Peter
Robertson, Adriana Z.
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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 the index’s holdings. As a result, various critics have attacked these
funds, raising concerns about their corporate governance incentives and
their influence on market efficiency.
We show this assumption is overly simplistic. 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 to holding even a representative sample of the
underlying index, nor do they commit to replicating the returns of that index.
Managers 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. While these departures are largest among smaller funds, they
are also present among megafunds: even among the largest S&P 500 funds,
holdings differed 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 flows.
In sum, S&P 500 index funds have substantial investment discretion,
which they exercise to an extent not previously recognized. Our findings
complicate the narrative around index funds and weaken many of the criticisms
levied against them. At the same time, to the extent that investors—and
particularly retail investors—fail to recognize this discretion, our findings
suggest they may not be getting what they expect.