Advisors, beware—the asset managers of index funds might be changing their target indexes without you noticing. A new study from Morningstar, “Transforming Index Funds: More Than Meets the Eye,” found that about one-fourth of index funds it examined switched target indexes at least once since their inception. Depending on how significant the change is compared to the initial indexes the funds tracked, such moves can impact the risk/return profiles that investors will see.
“We know it happens more often than the general public would probably recognize, but I was a little bit surprised at the scale,” said Daniel Sotiroff, manager research senior analyst, passive strategies, with Morningstar and the report’s author.
The Morningstar study examined approximately 1,200 index-tracking funds’ SEC filings and websites to identify any changes to investment strategies. It concluded that 310 funds switched target indexes at least once, and 57 switched indexes multiple times.
Asset managers with $500 million in AUM or more, including BlackRock, Invesco and Vanguard, tended to switch target indexes on their funds more frequently than their smaller peers. For example, Invesco was responsible for 60 index changes included in the study, iShares for 49 and Vanguard for 30. However, most of the bigger asset managers’ changes tended to be minor, rarely resulting in significant overhauls to the funds’ risk/reward formulas. Morningstar considers minor changes to include switching to a different target index in exchange for lower licensing fees or trying to reduce trading costs by spreading trading activity over several days or quarters.
Smaller asset managers, on the other hand, were more likely to make drastic changes to their index-tracking strategies, including switching asset classes and investment styles or going from large caps to small caps. Sotiroff mentioned one ETF that started tracking Latin American real estate and then switched to tracking cannabis. “Those are the big, wholesale changes investors really need to look out for because those are the ones where you are not going to be getting what you originally signed up for,” he noted.
This trend is driven by the pressure smaller funds can face to increase their inflows quickly if they are to survive. To grow their assets under management, they might abandon a strategy that’s not getting traction for one that may seem more in vogue, Sotiroff noted.
Morningstar data indicated that most funds that switch their target indexes tend to do so within the first few years after inception, with more than 80 of the tracked funds making these moves in years four to six of their existence. Another 70 or so funds made such changes two to four years after inception. Changes later in the funds’ life tended to be rare.
However, Morningstar found that making drastic changes to their index-tracking strategies often doesn’t help smaller funds attract new inflows. Approximately 43% of funds that changed the indexes they tracked experienced outflows after they did so. An additional 35% of funds saw inflows that totaled $100 million or less. According to Morningstar, the funds that saw $1 billion or more in inflows in the 12 months after they adopted new target indexes tended to be larger funds like those managed by Vanguard and BlackRock, which were likely already popular with investors.
So, how can advisors ensure they don’t unknowingly continue investing in a fund that might have completely overhauled its risk/reward profile? Sotiroff encourages them to at least briefly look at every notification they might get regarding new amendments to the funds they invest in and periodically check through the SEC website or the funds’ websites that the indexes they are tracking have remained the same.
“My impression is [advisors] probably don’t know this happens as often as you would expect. To the extent they are using the smaller funds that are probably going to be more susceptible to those changes, I think it’s important that they recognize that it’s a risk,” he said.
