How Discretionary Decision-Making Impacts the Financial Performance and Legal Disclosures of S&P 500 Funds

Abstract

When investment funds track the S&P 500, the index becomes more than just a list of 500 companies. The focus then turns to the financial and regulatory issues that arise from the discretionary decision-making of the Index Committee that governs the S&P 500. The discussion of these issues and their implications should be of extreme interest to both investors and regulators. Such discretionary decision-making is not illegal and from a business perspective it may be required. For example, if the Index Committee wants to exclude companies with dual class shares, that is its right. However, it needs to be disclosed to investors in S&P 500 funds that sub-optimal returns may result.

Based on our empirical research and analysis, we recommend a new principal risk disclosure under SEC Form N-1A, which we refer to as “selection risk,” that is to be included in the statutory and summary prospectuses of investment funds that track the S&P 500. It is a risk that results when the Index Committee uses its discretionary decision-making to exclude stocks or group of stocks which may outperform the index and not allow S&P funds to create portfolios of stocks which most accurately represent the market risk and expected returns of large cap, Blue Chip America. This new disclosure will provide investors with the necessary information to evaluate whether index funds that track the S&P 500 are appropriate for their investment needs. Moreover, we argue that the S&P 500 index is no longer an appropriate broad-based securities market index for purposes of Form N-1A benchmarking.

Our paper makes contributions to the literature on index managers and the SEC’s disclosure policy for open-end investment management companies. Most importantly, it will help guide the investment decisions of tens of millions of investors who are currently invested in, or are considering investing in, funds that track the S&P 500.

Keywords: prospectus, form n-1a, open-end investment management companies, index, sec, securities, s&p 500, index effect, legal disclosures, index funds

JEL Classification: K2, K22, H72, H75, J26, J32