Financial Safety and Oversight of Stock Market Index Funds

October 7, 2014 12:12 PM

What particular measures are in place to oversee stock market index funds and ETFs to make sure their financial management is on the up-and-up? Aside from the usual auditing that happens at all corporations are there any special procedures that apply to the fund industry? What are the chances of a significant accounting scandal at one of the major fund companies?
posted by storybored to Work & Money (7 answers total)

Mutual funds, including index funds, are subject to particular scrutiny by the SEC. There is an ongoing investigation of PIMCO's Total Return Bond ETF centered on allegations that they used some shady accounting of bond prices to artifically inflate their returns to attract more investors. This has been very big news in the financial sector that has implications for all similar bond funds. There have been a lot of rumors in the financial press of a broader probe into disclosure issues at ETFs across the board. PIMCO is THE 900 pound gorilla of the bond mutual fund world, so I'd say the chances of a scandal at a "major firm" are pretty good. At the end of the day, I'm not exactly sure what will come of it. Its not unlike the credit default swap problem from the mortgage meltdown -- instruments that do not have an active market are difficult to price fairly and it is going to be a challenge for the SEC to prove that PIMCO didn't come up with an accurate price since in some cases, they more or less are the market for many issues.

There is increased scrutiny of ETF and mutual funds when compared to generic equity in conventional companies, but many might question if the scrutiny is adequate to ensure appropriate accounting and investing standards. The regulatory basis for the SEC scrutiny is usually the Investment Company Act of 1940, which subjects companies whose business is investing to special attention. However, most of the real action is in a massive collection of exemptions and guidance from the SEC governing the permissable usage of things like derivities and leverage (among many other details not covered in the 1940 legislation).
posted by Lame_username at 1:06 PM on October 7, 2014 [1 favorite]

Here is a link to the website maintained by the SEC for individual investor education, at the page that explains ETFs, describes them in general terms, and provides links to further information on them.
posted by janey47 at 1:18 PM on October 7, 2014

significant accounting scandal

Because the funds are separate legal entities from their sponsors and are audited, and most index tracking funds are fairly simple (just hold basket of stocks as defined by an index) a significant accounting scandal is very unlikely. Furthermore, fund units are created in the marketplace by trading desks buying the underlying stocks in the appropriate proportions and turning them into shares of the ETF. The further away you get from a plain vanilla fund, the greater opportunities for problems.
posted by shothotbot at 1:20 PM on October 7, 2014 [1 favorite]

You specifically stated index mutual funds. In this case the risk is low because anyone can easily compute the exact value of the index at any point in time from public information, and therefore the value of your shares. There's very little room for deviation, down to a tiny fraction of a percent. Small deviations are due to exact costs and efficiency of block trading, securities lending, and expense ratios. Expense ratios must be declared for full transparency.

For ETFs, their very operating mechanism insures that fund prices can't deviate too much from their real market value. Anyone can compute the exact value of the shares from public information. Dealers have the right to trade underlying stocks for fund shares or conversely fund shares for underlying stocks if the fund price deviates too far from their intrinsic value, ensuring that shares are correctly priced. Small deviations can occur temporarily due to liquidity but typically amount to fractions of a percent.

So for index funds and ETFs, there is full transparency. The investing public knows exactly what assets the fund is holding at all times, the prices for those assets, and therefore you know exactly what your shares are worth at any point in time.

On the other hand, actively traded funds like PIMCO mentioned above are not transparent. They don't disclose their holdings in real time. Further, as in the PIMCO case, they may be holding assets that are difficult to assign values to. Creative accounting can lead to disputes about their real value.
posted by JackFlash at 1:32 PM on October 7, 2014 [2 favorites]

Virtually all mutual funds both active and passive use a third party for custody. Even if some funds may hold assets that are not actively traded someone who isn't the manager is ensuring the assets the manager claims he owns, he actually owns.

ETFs use an arbitrage to keep prices in balance so there isn't anything to actually cheat on.
posted by JPD at 5:11 PM on October 7, 2014 [1 favorite]

So for index funds and ETFs, there is full transparency. The investing public knows exactly what assets the fund is holding at all times, the prices for those assets, and therefore you know exactly what your shares are worth at any point in time.

On the other hand, actively traded funds like PIMCO mentioned above are not transparent. They don't disclose their holdings in real time. Further, as in the PIMCO case, they may be holding assets that are difficult to assign values to. Creative accounting can lead to disputes about their real value.

You are mistaken on a few issues, primarily illustrated by the fact that the investigation into PIMCO and into other bond funds is entirely about an ETF. In that case, the focus is not on the contents of the ETF, but rather on the valuation of the assets contained within the ETF.

The other issue relates to the transparency of ETFs in general. It is true that actively managed ETFs (not index ETFs!) are required to disclose their holdings on a daily basis, but what is not widely understood is that those holdings are what is called a creation basket, which is technically the exact mix of shares required to be delivered by an institutional investor who wishes to create a new tranche of ETF shares. For most funds, these funds would exactly match the current holdings of the fund (otherwise, there are interesting arbitrage opportunities created), but it turns out that not all funds have identical actual holdings. A quick google search turned up this 2010 article, but the underlying points made in the article remain accurate.

Further clouding the waters, there are also Non-transparent ETFs whose disclosure rules are essentially the same as mutual funds.

Also, most index funds seek to maintain parity with their index through derivities -- this is critical for them because otherwise adding or removing issues from the market basket will generate tracking error. It is easy for the index to just declare stock A is out and stock B is out and use the closing price to set the value, but the funds who track the index must actually execute massive block trades in those issues and they will never manage to get the actual price that the index used. In the event of a counterparty bankruptcy, those funds could experience massive losses and break violently from the index value. This is a particular risk with families like ProShares, who trade almost exclusively with derived products.
posted by Lame_username at 8:11 AM on October 8, 2014

You are mistaken on a few issues, primarily illustrated by the fact that the investigation into PIMCO and into other bond funds is entirely about an ETF.

The OP asked specifically about index mutual funds. The PIMCO ETF is actively managed. This is a good reason to only invest in diversified index funds and avoid actively managed and narrow sector funds. Worse, actively managed ProShares ETFs often use leverage which is reason enough to avoid.

Some index funds do use a small amount of derivatives to avoid front-running for new index entries, but these are temporary and a very tiny percentage of fund assets, by nature. You can avoid front-running almost entirely by choosing a total market stock fund.

The best advice is to choose a diversified, liquid index fund and compare its performance to the index itself. The difference should never be more than a few basis points minus the published expense ratio. If that is the case you can be pretty sure you are invested in what is advertised.
posted by JackFlash at 9:06 AM on October 8, 2014