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Standard & Poor's Executives Discuss Future of Indexes

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Excerpts from roundtable discussion with Bob Shakotko, Senior Vice President, S&P Index Services and David Blitzer, S&P 500 Chief Strategist. The full version of the interview was originally published in the December issue of The Index Insider, a new subscription-based email newsletter by IndexFunds.com. For more information about the newsletter, please email John Spence, Associate Editor.

Interview By Jim Wiandt, Site Editor

WIANDT: Questions from Jim Wiandt
SHAKOTKO: Bob Shakotko:, Senior V.P., S&P Index Services
BLITZER: David Blitzer, S&P 500 Chief Strategist

WIANDT: What are some of Standard & Poor's strengths as an index provider?

SHAKOTKO: I think you could really go back to Standard & Poor's strengths as a company to partially answer that question, and then we'll get into some of the more specific strengths as an index provider. As a company, we have I think what Wall Street considers to be an extraordinary degree of independence of view, and we approach things without prejudice as an information provider, and a company that analyzes other companies, I think our opinions are valued. To drill down into the index business, we've taken a tactic there of providing what I might call useful indices…indices that you can build financial products and investment products on. And that's really what distinguishes us from some of the other index providers, that we've gotten down to a level of granularity and usefulness in our indices that people can use our indices as a backbone of investments. So in a nutshell, that's where I think our strengths really lie.

WIANDT: How many people work at S&P on the index services end?

SHAKOTKO: I answer that question in a couple of ways. The easy answer, the short answer is right now about 60 people work in the Index Services Group. Index Services now at Standard & Poor's is a bit like an onion, there are layers all around it. And we're, the 60 people in our group are just the core of the onion. We have a lot of people who support the indices in direct and indirect ways, in quantitative groups and analyst groups around the company. So altogether, you'd have to add, I don't know, maybe a couple hundred people to that 60.

WIANDT: What's the breakdown of that 60? Are they mostly managing the indices, are they mostly sort of PR, sales, information people, and what's the breakdown of that?

SHAKOTKO: Three groups in Index Services. The first group is Operations. Those are the people who actually make sure that the index gets calculated, calculated correctly and disseminated to the right places and the right quote services. We probably have about 35 or 40 people working in that area. The second group is generically described as Business Development and Marketing. These are people who work with exchanges, who do index engineering, who work with clients and promote our indices and understand the client needs and so forth. All together, we have eight or nine people in that group. Eight or nine or ten people in that group, let's say. And then we have a Licensing group, with a few people, about six or seven people there.

WIANDT: I guess then for David, what exactly is involved in creating and maintaining indices?

BLITZER: On the creating side, I think you start with an idea of a market and an asset class that makes some sense, and can be well-represented. What is a reasonable number of securities? What are the requirements in terms of making sure that the index is sufficiently liquid and investable, that an investor can really buy the index and get the same results in the market as one would calculate theoretically off the closing prices of the securities and other supporting information. In terms of maintaining it and tracking - keeping up to date on the corporate action, understanding the corporate action. And then as new wrinkles come up, recognizing the new wrinkles and sitting down and figuring out how to handle them, tracking stocks that didn't exist 10 or 15 years ago, trans-global corporations didn't exist till then. It may not exist now but that's the way it was pitched to us at the time. So on and so forth. There is never a dull moment, but each one of those has to be reviewed and a decision has to be made as to how it fits into the index.

WIANDT: On the local level, like say in the international market, how much control, how much autonomy do the local people have and to what extent is the final decision on composition made in your office in New York?

BLITZER: For each index, or in some cases a group of related indexes, there is an index committee. Typically it's five to eight people. Most of them are only S&P employees. In a couple of cases where the indexes were inherited from an exchange, the exchange may have minority members on the committee. The relevant committee makes all the decisions. The committees coordinate by having two of us, myself and one of the operations people, who sit on almost every committee. They're all interlocking in some way.

WIANDT: Are the decisions made by casting votes or is there unanimity in the end on how do you actually come up with who's coming in and who's going out?

BLITZER: I call a consensus; if there's a lot of disagreement, we go around the table three or four times.

WIANDT: What do you think of the price-weighted Dow Jones Industrial Average? And what are S&P's arguments for the 500 as a proxy for the U.S. market or the U.S. large cap end?

BLITZER: In terms of price weighting, Dow itself - or at least I've heard them say in public - said that price weighting was used because back in 1896, the adding machines of the period weren't too widespread. So they found 12 stocks, added up the price and divided by 12. Price weighting in terms of a vehicle for investment has a lot of problems. The stock's impact on the index depends on how high or low its price is, not on how big or small the company or how important the company is. It's very difficult to run an index and rebalance it on a regular basis when it's price weighted, it's just awkward all around. Cap weighting, on the other hand, is very easy to run, except for changing stocks or issuances of new shares, the thing is self re-balancing, which is a clear efficiency advantage. The cap weighting approach to an index ties right back to mean-variance analysis (Markowitz), in fact essentially all of the last 50 years of finance. So it makes sense that it's in there and it seems to be the right way to go. The 500, when it was originally conceived, was clearly meant to reflect the entire U.S. market, it represented something over 90 percent of the U.S. market cap. The market's expanded since 1957 - it's grown not only in dollars, but it's also grown in the number of stocks out there. And the index today probably represents about 70 percent of market cap. If you turn that into a representation you can really invest in, and eliminate a few illiquid companies, the 70 percent is a little bit higher. As a single index that's well understood, well represented, and has broad coverage, it is I think still the best single index out there in terms of the entire market. A total market index is like Wilshire 5000 has 7700 stocks. Nobody buys all the stocks. Vanguard's own Wilshire Fund, I think, owns about 3100 to 3200 stocks because they optimize it. Most years the Vanguard 500 Fund would be a better optimization than the Vanguard Total Market Fund for the Wilshire. So I think the 500 is still the best single measurement that's investable that's out there for the overall market, with the possible exception of our own 1500, which is mid cap and small cap stocks, is not quite as widely known and does not have the same long history, because our small cap only goes back to the early 1990s. But I think either the 1500 or the 500 is the best way to view the overall market.

WIANDT: Do you have some sort of general guidelines about the maximum turnover that you'll have in an index in a year? Or is that fully at the discretion of the managers?

BLITZER: That's to the discretion of the manager of the index committee. We like to keep it low and on a cap-weighted basis, the turnover of the 500 is usually five percent or less - which would be like a mutual fund where the fund manager would sleep 240 days in a year or something.

WIANDT: It looks like the turnover is at 40-something slots in the 500 so far this year, but on a cap-weighted basis, this is less total money you're talking about?

BLITZER: Well if we hit 50 this year, which seems to be the local guess, that's ten percent in terms of the names. But they're not all - some of the names are relatively small, so it's probably about five percent on a cap-weighted basis.

WIANDT: Right. To what degree does Standard & Poor's consult with fund managers in determining the component stocks of the indices?

BLITZER: In terms of the component stock, none whatsoever. We answer questions about it after the fact - we don't consult with anybody beforehand.

WIANDT: Do they ever talk to you about specific issues like keeping the index liquid in terms of they'd like to see more technology or more small or whatever? I mean how much interplay is there between you and the fund managers?

BLITZER: Well we get a lot of advice and opinions offered. There's also sort of a mini-industry in that neighborhood of people trying to know what we're going to do before we do it so they can trade on the guess. You know, we listen to lot of things. We say very little when it comes to what's going to be added or what's not added, until we make the announcement.

WIANDT: With the S&P/Barra style indices, how would you stack them up next to Dow and the Russell indices, in terms of efficiency and accurate reflection of style? Because it seems like in addition to the sector breakdowns, increasingly style is becoming important too.

BLITZER: I think style is important. The S&P/Barra style indexes go back I guess eight or nine years ago, when they were put together. A joint effort of ourselves and Barra. And Barra brought in Bill Sharpe to do most of the legwork. Unlike some of the other ones, these are pretty solidly anchored in finance. They're based Fama and French's work, the so-called three-factor model. They use book to price as the growth/value deciding factor. I think they're consistent that way. They will put a stock in all value or all growth. I remember a few years ago, The Wall Street Journal ran a list of the top ten growth stocks and the top ten value stocks of the quarter from Russell. Six of the top ten growth stocks were on the value list as well. We don't have that kind of issue. So in that sense, I think there's a firm basis for what they're supposed to do, and I think they work well. There's a lot of discussion that goes around - we've listened to the discussion, so far I don't think we've seen any conclusive argument that we should switch to some other method. We're going to keep listing, but we're not about to run out and switch at this point.

WIANDT: I mean obviously that would be problematic for the funds too. You know, the funds that are tracking the Barra now, if you changed to another system, they would have some problems.

BLITZER: That's true. I mean making a change is something, there's got to be a clear gain no matter what. And at this point, not only don't we see a clear gain, I don't think we see something that is an obvious close competitor to the way it's being done at this point.

SHAKOTKO: I guess I have a fair amount of experience on the growth/value side. Before coming to Standard & Poor's, I worked a lot on emerging markets indices for the World Bank. And we looked at these issues pretty carefully there. One of the issues with the Russell indices is that companies are value and growth in shades of gray, and while that may have a certain natural appeal to the philosophers among us, when it comes down to actually classifying stocks, it gets a little bit tricky. The industry has come to say Stock X is one thing, it's a buy or it's a hold or it's value or it's growth. It's an important way of communicating ideas to people. And if you then want to sort of change the way we communicate and say Company X is sort of value and somewhat growth, messages do not get communicated as clearly. So even though a philosopher might argue that a 0/1 value/growth characterization of the market is not the best, it certainly has some strong advantages.

WIANDT: The argument to people on the other side would be that if you split it right down the middle, you're going to have more turnover. And therefore, potentially less tax efficiency. If you have certain companies that are going in and out of the indexes at a greater rate, then if you had that gray area, you'd have maybe less tax efficiency.

SHAKOTKO: And that's been one of the traditional arguments. You know, it's the boundary effect - people wandering across the boundary. We've certainly recognized that. And again, you have to balance that off against the communication advantages. IBM is the perfect example in the Russell indices. It varies between 55 percent value to down to 45 percent value. And it's true that it doesn't - there's not very much of IBM that's transacted on the other end. When someone is forced to declare IBM is a value company or a growth company, if you have to pick one, you can't do that.

WIANDT: I'd be remiss if I didn't bring this up. To David. Do you think that Vanguard is going to be able to launch their S&P ETF early next year?

BLITZER: That one, that one we have no comment on. Anything like that, we have to refer really to McGraw-Hill.

WIANDT: Okay.

BLITZER: There's just too much going on right now to comment on it.

WIANDT: Okay. Anything else that either of you would like to add?

SHAKOTKO: To point out, Jim, just for the record, I guess, that we are the leading index company when it comes to having ETFs created on our indices. I think you knew that already, and I just wanted to make sure that the quote comes from us. We're obviously the leader in the U.S. market, just by virtue of the strength of Spiders and iShares products, based on our indices. In Canada, we've got the leading ETF there by far. We're looking at doing new products now in a number of places. Japan is one. Australia, there was an announcement made three or four months ago.

WIANDT: Right. With State Street.

SHAKOTKO: With State Street.

WIANDT: That was a big one. I thought that that might be an iShare pick-up, and then State Street came out and...

SHAKOTKO: Well I think there was a lot of speculation on that, and I'm not going to go down that path and speculate myself.

WIANDT: Well you probably don't have to speculate.

SHAKOTKO: But we're really proud of our record on this, Jim, and it is another demonstration of our commitment to good products out there. Products that investors can use and organize their investments around.

BLITZER: I guess the other thing is not only the products, but the indexes themselves, it's not the television index, but it is the investor's index more than anything else. And a peculiar piece of evidence is that once in a blue moon, when Dow Jones changes the list of names in the Dow 30, I think we get more phone calls than they do about what's going on and what does it mean and what do you do about this, and how they make this choice and the rest of it. So I think clearly we're the ones who are recognized by the investors.

WIANDT: Okay, thanks very much David and Bob and Michael (Privitera, Director of Communications).

S&P: Thank you.

SHAKOTKO: Let me just say, Jim, before you sign off, that when you're next in New York, please let us know ahead of time. We'd love to give you the cook's tour.

WIANDT: That'd be great.

SHAKOTKO: You could see our nuclear powered index calculator.

WIANDT: Sweet. I've been wanting to get my hands on that thing forever.

SHAKOTKO: We won't let you change any of the constituents in the 500.

WIANDT: Oh, just one.

SHAKOTKO: Well all right, if you can argue persuasively.

WIANDT: Okay. It's been nice talking to you guys.