interview

IndexFunds Speaks with Michael Petronella

interview

Michael Petronella is Managing Director at Dow Jones Indexes. He recently sat down with IndexFunds.com's, Site Editor Jim Wiandt to discuss the history of Dow Jones indexes, the free-float debate, and how Dow Jones plans to construct international country and sector indexes.

Mr. Petronella has overall responsibility for the day-to-day operations of this unit that formulates, markets and sells all Dow Jones indexes for countries, regions, sectors and industry groups.

Mr. Petronella joined the Dow Jones accounting department in 1974 and has held several positions, including accounting manager and budget director. He was named assistant comptroller in October 1993, with responsibility for the Dow Jones and Dow Jones Markets budget updates and the financial analysis section of the comptroller's department. Mr. Petronella was named managing director of the Dow Jones Indexes group in January 1997.

IndexFunds: What do you see as Dow's main strengths as an index provider?

Michael Petronella: I think we always lead naturally with brand - Dow Jones is considered to be a very strong retail brand. With respect to indexes, I think that we can claim that we're absolutely an innovator. We go back 100 and some years starting with the Dow Jones Industrial Average. Since then, in a relatively short period of time, we've innovated by bringing in the Dow Jones Stoxx family. We were first to this, really as a reaction to a macro-economic event. We introduced the Dow Jones sustainability index. Index providers with good cause have shied away a little bit from straight SRI [socially responsible] type indexing, and we found a way to bring a sustainable index, which really we're not saying who's green and who's not green. It's a quantitative index - it's put together with real rules, and then we have sustainable rules. And we've introduced the Islamic Index, which again is a niche market. We brought what we believe to be the next generation of style indexes [indexes based on large, small, growth and value stock sectors] to the market. So the fact that we've only been in this market for really three years, a little bit better than three years, in some ways is a disadvantage to us. In other ways, it's a big advantage, because we've seen what's been before us and been able to right some wrongs along the way.

IF: On the style indices, in particular, I think you can see the inefficiencies of some and see how you can make them work better with funds.

MP: I think when they were put together, they did the best that they could with the information they had. And markets have matured; information certainly has become a lot more accessible. And there's been a lot of batting around as to what's good and what's bad about what exists. So we're able to take a good look at that and say here's how we can improve it. And we think we have. We've moved quickly to free-float across all of our indexes, and we've increased the breadth of our coverage 95% on our benchmarks. So I think it isn't just a branding issue for us. It's really the strength of the index family, and we've really put it together in a relatively short period of time - three, three and a half years. And we've made it a full global family.

IF: I've seen the list. I can't keep track of them all.

MP: Well, hopefully the market doesn't view it as we're just cranking them out. Our goal naturally is to create indexes that have value, and frankly what we're trying to do in the global arena is really repeat the success we've had in Europe. But look at the way the markets have changed. Country investing used to be the way to go. Now it's moved to regional and sector investment. So we'll soon be coming out with a complete set of sector indices to address that. We think the world will get there. You have to be there when it's ready. If they're ready and you're late, you miss it. So we try to be a little bit ahead of the market.

IF: You mentioned the free-float debate. Can you talk a little bit about that?

MP: Well it's a big debate because of the money that's currently tied to indexes that are market-cap based. And there is going to be a big rebalancing for people who benchmark their money to non-float indices. I think float makes sense. It's not so much that it's the right or the wrong way to do it. I think it's the right way to do it when you're building an index. Because what you want to present is an index that can be invested in with what's available. And what makes float so interesting I think is that ultimately I think everybody's index series will be float adjusted. And I'd like to compare them. And my guess is that they'll all be different. Because float still is not an exact science.

IF: How does it work?

MP: Our rule set is that any block that is five percent or more owned by individuals, government agencies, or another company is excluded. So you don't get down to a finite, absolute measurement. But we think we're coming close enough and we certainly in a macro sense are making available to investors a segment of the marketplace they can invest in without trying to buy into a squeeze. And the indexes have really created a phenomenon when changes are made. We see it in the S&P 500 with stocks that come in or stocks that go out. There's a lot of volume on it. And just to take one example, Deutsche Telecom, which I guess has probably gotten the most press of any company that I've seen with float. If you're asking a portfolio manager to buy Deutsche Telecom into his portfolio, then he ought to be responsible for buying what's available and not trying to buy what's not available. It's still a supply and demand game. So that's the key to float and I think that index providers will ultimately all go that way, I think we've been, again, quick to recognize the need and the reasoning, and to put it together. It's not an easy task.

IF: What do you think about the S&P and Vanguard lawsuit concerning index licensing for ETF products?

MP: I know the fringe information that's been published. I don't really have any comment and I don't know what the contractual relationship is between S&P and Vanguard. I'm also not an attorney, so even if I did know the contractual relationship, it wouldn't help me.

IF: What are the implications of that in terms of exclusivity agreements and issues like that? Do you face those sorts of issues yourself?

MP: Certainly your contractual agreements must state what your intent is, and I think that from a contract standpoint we're very careful to make sure that the language in the contract says what our intended purpose is. Therefore it's almost like strong fences make good neighbors. Strong contracts make good partners. And we take our time with contracts, as do most of our counterparts. And contract negotiation is not an easy thing, but at the end of the day if you've got a good contract you should be able to avoid some of this. You're never going to avoid all of it, but you're going to avoid most of it.

IF: How closely related is Dow to the Wall Street Journal now? Is there any interaction at all with the editors in terms of indexes you might want to do, in terms of companies that might be in those indexes?

MP: Let me start with the Dow Jones Industrial Average. Of course, the average is very much associated with the editors of the Wall Street Journal. They are the auditors. They are the choosers of the components of the index or indexes. In terms of the global indexes and the other indexes that we create, they're all rule-based, they're quantitative in nature. So they're not stock-picked; they're not committee-picked. They're determined by a set of rules. In terms of our relationship with the Wall Street Journal and our Dow Jones Newswires operation, it really comes down to more of their intelligence-gathering capabilities. We're able to utilize their knowledge of the markets to help us with classification issues and so forth, which is sometimes difficult. Because they may know we can ring up a reporter in Europe or in Asia and ask him about a specific company, because chances are it's in his beat. But inclusion for most of our indexes are quantitatively based. And if there are judgments to be made, certainly we have the world's premiere provider of business information and news.

IF: How does the process work? Are you involved in the process of selection for the Dow Jones Industrial and the other Dow indexes?

MP: The averages are in the strict domain of the managing editor of the Wall Street Journal.

IF: Is it just up to one person?

MP: There's a committee of people. But in a general sense, they're looking for companies that are well established, have long track records of earnings growth.

IF: What do you think about price weighting? Is there any possibility that might ever change?

MP: In the case of the Dow Jones Industrial Average, I love price weighting.

IF: Nice round number up there.

MP: Yes, I think that it's pretty obvious from the way we currently calculate indexes that we're in favor of cap weighting as an index group. The only indexes that we have price weighted are the averages. And the reason for that really is historical. Way back when Mr. Dow created them, in the late 1800s, the concept of market capitalization was a little squirrelly. So he did the best he could with available stocks and created a price-weighted index. But certainly if we were to create the Dow Jones Industrial Average today, it probably wouldn't be price weighted. But the strength and the history behind the Dow Jones Industrial Average is pretty awesome. And if it ain't broke, don't fix it. It seems to be performing the task it was intended to perform. It's meant to give an idea of market direction, and it certainly does that. So we're pretty pleased with it.

IF: Are there any ways to sort of leverage that name and tie fund money to it?

MP: Actually, that's an interesting question. We've never had a fund manager approach us and say, "Gee, I want to license from you the Dow Jones Industrial Average, but I want to cap weight it." I think that would be a difficult marketing problem for the fund company because if you're going to track an index, you ought to track an index. And if your methodology is completely different, how do you sell it?

IF: It would look different, I mean the returns would look different probably.

MP: It'd have huge tracking issues, and if you're out there selling that I don't know how you'd market it. We've actually never been approached, so we've ever even considered it. So perhaps the obvious is that obvious, it just wouldn't work.

IF: What do you see as the Dow sort of equivalent to the S&P 500 - a broad proxy for the market, but that's also usable to track for an index?

MP: Well I think the Dow 30 is the blue chip barometer of the market. It's a barometer for most of Main Street for what the market is doing. If people ask you, "Where is the market?" they're not asking for the S&P, they're asking for the Dow. And that's its beauty, its simplicity, people understand it. It's 30 names. They all know the names. Even the S&P 500 is difficult for anyone to know all 500 names. The Dow is a very simplistic approach to measuring the market trends of the U.S. market. And it's done a wonderful job for more than 100 years, and we expect it to continue to do so. It certainly is an investable index as well. We do have an exchange-traded fund based on it, we have futures and options based on it, and we have some funds based on it. And over long periods of time, its correlation to the S&P 500 is very high, 90 percent.

IF: What's the process for setting up international indexes?

MP: It really depends on the index. With the Dow Jones Global Index standard, what we're trying to do is create indexes that are representative of the markets that they cover in the broadest sense. So we start with a rule set, which in our rule set is 95 percent of the market capitalization of any given country or region or sector. From there, we basically employ certain liquidity screens to make sure that the components of the indexes will be able to be bought and sold. And then we start to fill the industry group and sector classifications based on our classification structure.

IF: Of that 95%, do you knock off the illiquid companies from that?

MP: Yes. So when we say 95 percent, we are not saying that that's 95 percent of the total market capitalization of the country. We're saying it's 95 percent of what we believe to be the investable market of the country. So if a stock is listed but doesn't trade, it will not make our universe, a 100 percent universe. That's already out. Just to give you an idea of the US market, there's some 7,500 securities, give or take, and our index is about 2,000 securities. And that covers the 95 percent. But if you look at those 7,500, there's some that will not even make our 100 percent index because they don't trade.

IF: Vanguard, for example, their Wilshire 5000 Fund has 3,100 stocks in it. 3,100 stocks is a lot.

MP: There's no one, to my knowledge, that replicates the Wilshire 5000. It's a roach motel, you can get in but you won't get out. So from that point of view, all we really have to do is we have to establish percentages. In developing markets we're covering at 95%; emerging markets we cover at 80%. And then it's all qualitatively driven.

IF: How do you keep track of all the corporate actions that affect the indexes? How many people have to work on it?

MP: It's not easy. We have several data providers that we get corporate action information from. And from a standpoint of staff, we've got roughly seven people in Princeton, not all gathering corporate action data. But that's our total staff. We try to have country experts where we're looking at particular countries or regions. And we try to put a bunch of checks and balances in place that are going to prevent us from missing corporate actions, because that is the essence of maintaining an index.

IF: How many countries are we talking about?

MP: Currently, 34.

IF: And where are you looking to expand beyond where you are now?

MP: There are some European countries that we'll add in. Some of them will come as a result of joining the European Union (EU). We're looking to increase our coverage of emerging markets, so we look towards South America, Asia, some of the eastern European countries. We're looking at these now and we'll add them to the index when a few things happen, when they make sense, when we can get the data and when we feel we're in a position to maintain it effectively.

The full-length version of the interview with Michael Petronella can be found in the January issue of The Index Insider, the IndexFunds.com monthly paid newsletter with detailed information and data from within the industry.

The January issue of The Index Insider contains:

  • Q&A with Dow Jones Indexes
  • How New SEC Rules Affect Individual Investors
  • Discussion on how Morningstar calculates Price/Earnings Ratios
  • Study: Comparing Returns of Mutual Funds to Benchmarks in 2000
  • Appendix I: Historical returns of over 250 Major Indexes Worldwide
  • Appendix II: Complete Breakdown of ETF Returns and Data