Two veterans and a relative newcomer discuss the methodologies and practices that have made their indexes successful.
In October 2012, Vanguard fired the shot heard around the indexing world. The largest fund indexing firm on the planet announced that it was changing the benchmarks for a number of its funds from MSCI to a mixture of indexes provided by FTSE and CRSP, the University of Chicago’s Center for Research in Security Prices.
Vanguard’s move illustrates how quickly the index industry is evolving. Index providers have moved from methodological convergence in the market-cap-weighted “bulk beta” corner of Index Land to exploring the next great frontiers in areas such as “smart beta,” as they attempt to isolate factors other than market beta in hopes of generating indexes that will beat their market-cap-weighted cousins over the long haul.
To explore this new era of indexing, I hosted a panel discussion on Oct. 3 at the 2013 Morningstar ETF Invest Conference. Joining me were David Barclay, the chief operating officer of CRSP; Craig Lazzara, the senior director of index investment strategy for S&P Dow Jones Indices; and Raman Subramanian, executive director of index research at MSCI.
Our conversation has been edited for clarity and length.
Ben Johnson: Over the past few decades, we’ve seen a lot of convergence in the practices and methodologies used by index providers. Is there any room left for differentiation in the traditional cap-weighted benchmark space? How can you as index providers differentiate your core products?
Raman Subramanian: That is a great question. On the beta level, MSCI US All Cap Index includes large, mid, small and micro, and the CRSP Broad Market Index, for example, includes large, mid, small and micro. Those are the features. That’s what you are seeing. But it’s like when you compare two cars side by side; both cars can take you from one place to another. But when you open their hoods, you want to understand exactly how their engines work. How the engine works is crucial for index investors. Providers are capturing the beta, but how effectively are they capturing the exposure? Ultimately, a person who is buying an ETF is buying an exposure, and exposure is critical to investors.
Now, to capture the broad market beta, we know that markets have evolved and benchmarks have evolved, and at the broad beta level, if you look at the correlation levels, they’re quite similar. But to capture the beta in the most efficient manner, each of us has a different philosophy. At MSCI, we have put a lot of investability features into building the benchmark, ranging from how to capture the free float, how to liquidate, how frequently we want rebalance, how the IPOs come in, and how to mitigate front-running of the benchmark—because as you bring transparency to the benchmark, front-running can happen to the benchmark. We all want to achieve a transparent, rules-based benchmark. That’s the goal. But in the process of differentiation, if you add new features that are going to decrease the transparency and reduce the exposure level for the investor, that will create a challenge for the user. The challenge in the process is keeping indexes transparent, but also preventing investors from front-running or gaming the index.
Blood on the Streets
Johnson: Craig, what do you think about differentiation and the potential for certain features to sacrifice transparency?