While we continue to believe passive investing plays an important role in building diversified, low-cost portfolios, today’s market environment reminds us that choosing an index is itself an active decision. Understanding what sits inside an index, and how those constituents come to be included, has become just as important as selecting an active manager.
Most investors assume that when they buy an index fund, they are simply following the market. However, the following extract from Reuters, highlights that behind every index, such as the S&P 500 or MSCI Emerging Markets Index, there are committees making subjective decisions about which companies, countries and securities qualify for inclusion. Those decisions can influence the flow of trillions of dollars and significantly affect company valuations.
‘When Standard & Poor’s unveiled its new “500” index to financial writers in 1957, guests sitting down to lunch in New York could not have imagined that this analytical tool would one day guide the destination of trillions of investment dollars. Yet the relentless rise of low-cost index-tracking funds means any tweaks S&P and its rivals make to their benchmarks are now major events in global markets. Greater scrutiny is inevitable and potentially awkward.
Consider two major recent decisions. Earlier this month S&P Dow Jones Indices concluded, after a consultation, not to make any changes to its flagship index to accommodate the arrival of so-called “MegaCap” companies. This technical judgment means SpaceX and Anthropic will not get speedy admission to an index tracked by funds worth about $13 trillion. MSCI similarly opted to maintain the status quo this week. The company decided not to promote South Korea from an emerging market to a developed market, while postponing the possible relegation of Indonesia to lesser frontier market status. The result is that funds worth roughly $1.4 trillion, following MSCI’s Emerging Markets Index, will continue to rise and fall with runaway chip giants Samsung and SK Hynix, which together make up almost 15% of the benchmark.
These judgments reveal an uncomfortable truth about index investing. For all the talk of “neutral” and “passive” asset allocation, maintaining a benchmark means making constant subjective calls about the suitability of companies based on size, profitability, and free float. Firms adapt their listings to qualify for certain indices; investors try to anticipate which stocks will make the cut. There’s also evidence that members of the S&P 500 club enjoy higher valuations than smaller but faster-growing companies.
Some decisions are momentous: China’s stock markets were already the world’s second largest when MSCI first admitted mainland equities to its emerging markets index in 2017. Meanwhile, the explosion of giant private companies meant SpaceX instantly became the seventh-largest listed U.S. company. There are no easy answers.
Yet these choices are being made by private companies with financial motivations. Both S&P Global and MSCI earned about $1.8 billion in revenue from their index units last year. And while S&P resisted pressure to give SpaceX special treatment, rivals Nasdaq and FTSE Russell tweaked their rules to favour Elon Musk’s rockets-to-chatbots company. The judgments are also far from transparent: you will search corporate websites in vain to find out how many people sit on the committees making index decisions, let alone their names.
Of course, investors are free to choose whether or not to follow an index. Benchmarks which prove capricious or excessively volatile will lose customers. Even so, the gradual transformation of a niche analytical exercise into a fulcrum for global markets recalls the way credit ratings agencies became unwitting enablers of the debt bubble of the early 2000s. The subsequent crash led to intense scrutiny and increased regulation.
A sharp stock market correction, or the collapse of a few big companies, could have severe consequences for index-tracking investors. The resulting inquest would stretch far beyond a few dozen journalists having lunch in New York.’
Extract from Reuters “Breaking Views” weekly newsletter – Reuters, July 2026
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