Vanguard social-investing error prompts funds to check controls

The mishap raises new questions about how ETF managers monitor the indexes that underlie their portfolios.

Managers overseeing trillions in exchange-traded funds have been quietly meeting around Wall Street this week to check the quality controls on their funds, rattled after Vanguard Group Inc. mistakenly added shares of 11 companies, including a gun manufacturer and a private prison operator, to its $578 million socially responsible ETF.

Vanguard apologized to investors, citing a mistake in the underlying index provided by FTSE Russell, and both companies are adding new controls in the aftermath of the error, according to Vanguard spokeswoman Carolyn Wegemann. FTSE has agreed to provide justification for all future additions to its ESG benchmarks, and Vanguard will review them independently, she said.

FTSE is “committed to strengthening our processes in this space,” said company spokesman Tim Benedict. He declined to explain how the mistake was made or give any detail about how the company is responding.

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While the error at Vanguard was short-lived and the dollar value small, the mishap raises new questions about how ETF managers monitor the indexes that underlie their portfolios, whether or not they have a socially responsible mandate.

Last year, S&P Dow Jones Indices failed to remove a company that axed its dividend from an index of dividend-paying companies, the Financial Times reported. The error resulted in unexpected losses for investors in a State Street Global Advisors ETF that tracks the index, called SPDR S&P U.K. Dividend Aristocrats.

A representative for S&P Dow Jones Indices declined to comment, but said the index provider maintains “rigorous quality assurance processes.”

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Manooj Mistry, global head of index investing at DWS Group, which runs the third-largest ESG ETF in the U.S., says the firm’s head of risk asked whether the firm was vulnerable to an indexer error. After reviewing the methodology of MSCI Inc., which provides indexes for DWS, Mr. Mistry said he was comfortable with the asset manager’s quality controls. Regardless, portfolio management teams are responsible for what he called a “sense check,” to make sure securities are appropriate for their funds.

At State Street Corp., “portfolio management and research teams do systematic analysis to ensure that the index meets its stated objective,” said spokesman Marc Hazelton. BlackRock, which has more than $2 trillion across its ETF products, including the two biggest ESG ETFs, didn’t comment on how the firm monitors the holdings in its socially responsible funds. Bloomberg, parent company of Bloomberg News, also constructs and licenses indexes.

Ultimately, humans have to check what’s in an index, said Mike Venuto, chief investment officer at Toroso Investments, which specializes in ETFs. Portfolio managers shouldn’t be “blindly buying” what an index suggests, he said. “The index is a research tool and you can buy bad research. If it’s an ESG fund, it shouldn’t just be the requirement of an indexer — it should be the requirement of the manager.”

ETF portfolio managers are expected to match at least 80% of their holdings to whatever index they’re tracking, with wiggle room to allow for pricing execution, liquidity or other concerns. Managers are typically focused on matching a benchmark at the lowest price, rather than the qualities of the underlying holdings.

The small, Frisco, Texas-based manager Impact Shares runs three ESG ETFs pegged to indexes provided by Morningstar Inc. When the indexes tracked by the funds make changes, the firm reviews the rationale with social-impact partners including the NAACP and YWCA USA, which also receive a portion of the management fees.

That process, said CEO Ethan Powell, requires Impact Shares to ask whether it’s “measuring the right things, do we have the right companies in the fund for the right reasons?”

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