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By Ann C. Logue

Indexing has been a winning strategy in terms of risk-adjusted and fee-adjusted performance, and it’s become hugely popular with investors. The problem is determining what an index is. The grandaddies of them all are the Standard & Poor’s 500, originally designed to reflect the largest public companies in the US, and the Dow Jones Industrial Average, which was part of an investment theory developed by Charles Dow. Standard and Poor’s used its index to promote its data and rating services, while the Dow Theory helped promote the Wall Street Journal and Barron’s. 

As the Efficient Markets Hypothesis seeped into market consciousness and exchange-traded funds emerged to allow for easy trading of indexes, the index business started to change. The publishers wanted indexes that performed well to maintain the attention of the media, and they wanted to attract licensing fees from money managers who offered ETFs and other investments based on their indexes. The result was indexes that didn’t quite look like unbiased measures of market performance. The Dow Jones Industrial Average includes retailer Walgreen Boots Alliance (NASDAQ: WBA) and restaurant company McDonald’s (NYSE, MCD) rather than any of the car manufacturers. I can’t imagine the Dow Theory still holds. In December 2020, the S&P staff replaced Apartment Investment and Management Co. (NYSE: AIV) with Tesla (NASDAQ: TSLA), despite already having other auto makers in the index and despite real estate maintaining its share of the US economy. 

A cynic might say that the Dow Jones Industrial Average is now managed to compete against the S&P 500 in the ETF market rather than show the relationship between the utility, transportation, and industrial sectors of the economy. And could Tesla have been added to the S&P 500 goose the performance of the index and draw even more money into S&P 500 index funds? 

The SEC’s staff must have the same observations. This week, the commission announced that it was considering whether index providers, model portfolio providers, and pricing services should be treated as investment advisors under the Investment Advisors Act of 1940. It looks like an overdue move.

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