Just what is your tracker fund tracking?

Beware conflicts of interest that could skew the index your exchange-traded fund is tracking against you, says Paul Amery.

Index-based investing has become very popular over the last two decades. It's easy to see why. All the evidence shows that the average active manager can't beat the main stockmarket benchmarks, especially after costs. Index funds and exchange-traded funds (ETFs) typically charge a quarter or less of the annual fee of an active manager. So if you can't beat the index, you might as well track it cheaply.

But what if the index your fund is following is flawed? The rumpus over the rigging of the Libor rate should make us all think twice. Perhaps the most damaging charge in the Barclays case was that the bank's Libor-setters were leant on by colleagues with large trading positions, who stood to benefit from a skewing of the rate. Although Libor has fallen out of favour since the financial crisis, the rigging of the benchmark has seriously damaged the City's reputation. Could other indices have similar problems?

The provision of indices to underlie trackers and ETFs is very big business for the firms involved. It would be commercial suicide for any of the big benchmark managers to allow any suggestion of impropriety. The major index firms all stress that both the selection of constituents and the prices used to calculate index levels are the result of independent decision-making.

But not all ETFs follow indices calculated by independent benchmark providers. Some are created and run in-house by banks and fund management firms. The index calculation function is supposed to be kept at arm's length from trading activities. But the trust in these 'Chinese walls' has taken a well-deserved knock after recent events.

Even if the index provider is notionally independent, there are still grey areas to be aware of. If the index firm is owned by an exchange, for example, might that affect the way benchmark constituents are picked? Nasdaq, for example, recently relaxed its 'seasoning' rules to allow Facebook early entry to the exchange's indices.

There are no hard and fast rules on finding the right index for your fund to track. But the financial crisis has reminded us to pay particular attention to potential conflicts of interest. When considering an ETF, check who owns the index provider, what determines the selection of index constituents, and whether the prices used to determine the benchmark's value are transparent and reliable.

Paul Amery edits www.indexuniverse.eu , the top source of news and analyses on Europe's ETF and index-fund market.

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