Consider the case of General Electric Co. GE is among the 100 biggest defense manufacturers by revenue, but its defense revenue accounts for only about 3% of the company’s sales, according to Sacknoff.
Spade excludes GE from its defense index because defense isn’t one of the company’s primary lines of business. “One of our rules is that a company has to be systematically important to the sector and the sector has to be systematically important to the company,” says Sacknoff.
To be sure, the use of discretion is more exception than rule, according to Vanguard. The Russell 3000 Index functions much like the tag line for the Ronco rotisserie oven of 1990s infomercial fame: “Set it and forget it.”
“Inclusion in market-cap weighted indexes such as the Russell 3000 is determined by objective eligibility criteria that are clearly set out in the index methodology documentation. There is no individual discretion applied,” wrote Chris Woods, managing director of governance, risk, and compliance at FTSE Russell. “Whether our clients track our indexes for passive investment products, use them as performance benchmarks or for research purposes—they need clarity and consistency on how these products are maintained.”
None of this is to say there’s a problem with S&P or Spade’s approach to selecting their index members. But when you’re investing in an ETF or mutual fund that tracks an index, don’t automatically assume that you’ve removed human judgment from your investment process. Tracking an index does not a passive fund make.
“You shouldn’t just put companies in an index,” says Sacknoff. “You should understand why they’re there.”
This article was provided by Bloomberg News.