John Prestbo, formerly editor of Dow Jones Indexes and instrumental in the index provider's founding, chatted with the Journal of Indexes recently and offered his views on the current state of the indexing industry.
Journal of Indexes: How has indexing changed since you were helping to get Dow Jones Indexes off the ground?
John Prestbo (Prestbo): It has become a lot more populated: There's more competition, and there are also more users of index products. It's grown considerably. Another change is that when we started Dow Jones Indexes, the ETF space was primarily basic benchmark indexes. But now it's increasingly diverse with leveraged and inverse and strategy and active. There are a lot more products out there for investors to choose from.
JOI: Do you think the increasing diversity in the index industry is actually leading to stronger, more useful products for investors in general?
Prestbo: Yes; the thing about innovation is that not everything is a home run in terms of gathering assets or in terms of simple utility in an investment program. But ideas need to be spawned freely and tried out, and if they don't work, you shut them down and go on to something else. We've seen a lot more of that lately, too. Everything was treasured and precious in the beginning, and now it's "spit them out and see what happens."
Sometimes, a little more thought could be given to the "spitting out" part, but I'd rather have it that way than restricted thinking.
JOI: Is the evolution of the ETF industry driving the index industry's growth, or is the index industry driving the ETF industry's growth?
Prestbo: The ETF industry has been the driver, because that's where the money is—or at least that's where the growing amounts of money are. Obviously, the vast bulk is still in the mutual funds, but ETFs are growing strongly— and the SEC requirement in the beginning that ETFs be based on indexes was clearly a boon for the index business. That is partly why we've seen a reinvigorated bunch of index providers and also why we see all this creativity on the index design front.
JOI: What are the index innovations in the past years that you think are the most useful or the most interesting?
Prestbo: Bringing indexing to commodities was a great innovation. I know that the GSCI index goes back quite a ways, but it didn't meet with instant success. The ETF boom kind of brought commodity indexing to the forefront and made access to that market particularly easy for a lot of investors. They basically could trade their exposure to commodities like a stock in an ETF vehicle.
Currencies are another asset class that has become much more available through stocklike treatment, which is really what most investors need in order to handle a new asset class. Real estate—same thing. The asset class innovation was a good thing, I think, for investors as a whole. It opened up avenues that didn't exist before.
More recently, we've had strategy indexes. Now, some of those were available very early on, because growth and value are strategies that come to us from the good old days. But we've moved beyond that now to indexes that take you in and out of the market depending on what's happening with volatility or some other factor. We've got target-date indexes that move people through their life span with investing in a mix of markets: stocks, bonds and whatever. Those are all great ideas.
Now we're into an era where there's all sorts of convolutions. Just about every index provider has offerings in this arena—volatility control and who knows what's coming down the pike? In fact, Dow Jones just put out two index families from professional investors that have developed strategies and written books about them, and now, put them into index form. We're pushing the envelope toward rules-based active investing. Will this be good for everybody? Absolutely not, but it's good for some people. A market exists for all kinds of investment approaches, but they won't necessarily become big blockbusters.
JOI: When do you think an index becomes too active?
Prestbo: It becomes too active if the investor can't anticipate what's going to happen next with the index in terms of its composition, weighting or whatever moving parts are involved in it. The essence of active investing is you give your money to somebody and they play with it without you knowing what they're doing precisely. So far, all of the "active-ish" or strategic indexes have rules that theoretically you could follow and produce a similar result. As long as there's that transparency, then I think you're still safely in the indexing realm. Once you get into trusting, then you're in the active realm.
JOI: Where do you stand on alternatively weighted or fundamentally weighted methodologies?
Prestbo: I think there are only two things in indexing that really make a difference. One of them is selection of the components and the other is weighting of those components. What fundamental indexing does, simply, is take the selections and weight them according to something other than market cap or price or whatever. It's just a different scale on which to arrange your weighting schematic.
I have no problem with the concept. What I think is not totally clear is the relationship between those weighting schemes and market performance, and I think that's simply because we haven't had enough time yet and enough different market conditions to test the concept. I have no problem with the theory. The practice, I think, is still to be proven.
JOI: Are there any trends within indexing or index-based investing that you think need to die quick deaths or that you see as potentially harmful to investors?
Prestbo: I have nothing against the proliferation of indexes—notice how carefully I said that—nonetheless, I think the danger is that investors will get themselves into something that they really don't know how to handle. The most prominent example of that so far has been the inverse ETFs. Those are daily trading vehicles that are not a buy-and-hold kind of investment. I know that doesn't have much to do with indexing, but it does in a way, because they're taking brand-name indexes and saying, "When they go down, you can make money, too." That's very appealing to people, but they don't know how to use them, or they learn how to use them in a very expensive way.
I think the danger is that a lot of products will be launched that will be appealing to certain people who have no way of putting them in their proper place within their portfolios because they don't understand them. The more convoluted and esoteric these index vehicles become, the greater the danger that more people will slip on the banana peel and say, "Indexing is verstunken—look what happened to me." But they just didn't use them correctly.
JOI: Is all the talk about volatility just hype, or do you think investors should really care about it?
Prestbo: Volatility is just another name for risk. Risk is lots of things, but volatility is one form of risk—and it's the most easily quantifiable form. Yes, I think investors ought to be aware of it, but I don't think they ought to be scared to death of it, because risk is what enables them to make money. If everything were risk free, there would be no returns. Risk is not the enemy—it just has to be managed. And managed how? Well, managed in relation to your own risk tolerance, whether that be emotional or reality based, because of your time frame, or something else. You just have to be aware of it and construct your portfolio accordingly. But without risk, there's no investing.
JOI: Some people feel the Dow Jones industrial average is becoming irrelevant when compared with broader indexes like the S&P 500. How do you answer that?
Prestbo: Every index has a purpose—or should have, let's put it that way—and a way of achieving that purpose. The purpose of the Dow Jones industrial average is to be a shorthand indicator of the market. Is it a benchmark in the commonly understood sense of the word? No. It's 30 stocks. But that is, in fact, the purpose of the index: to use 30 well-chosen stocks of leading companies in their respective industries as a microcosm of the broader market. That's its purpose—always has been since Charles Dow invented it. He invented it in an era when there weren't S&P 500s or Russell 3000s or Wilshire 5000s or any of those. For many, many decades it was the beacon that people looked at to see what the market was doing.
Now there are many other choices of indexes. But the Dow has a place in that pantheon because of its nature. The shoreline is all populated with lighthouses now. It used to be the only one. Now there's a whole bunch of them. But that doesn't make any one of them irrelevant; it just means you use it differently than you used to.
JOI: What do you currently see as the unexplored territory in indexing? What's left to index?
Prestbo: I think bonds, as an asset class, are still pretty "benchmarky" in nature, and there are strategies in bonds that can be explored. One of the things that needs to be fixed in bonds is transparency of pricing. Wall Street has had that little cash cow for years, and I think it ought to be taken away from them.
I think there are other asset classes that can be gotten at one way or another. We've seen, for example, these hedge fund replication strategies. We don't know if they work, but the idea is interesting because it gives you access to active managers that you wouldn't otherwise be able to touch with a modest amount of money.
I think that gaining access either to parts of the overall capital market or to money management strategies that weren't accessible before are good places for indexing to proliferate again.
JOI: Is customization going to grow further?
Prestbo: Customization is a marketing thing. It is banks and the like saying, "We want to do this and we want to put our name on it." And that's all that is. It's really not about breaking a lot of new ground with customization—they're basically just rebranding it.
JOI: Can you handicap the current field of major index providers? Who do you think is going to, essentially, come out on top from the current field? Will there be further consolidation?
Prestbo: I hear rumors about various index providers that they might be rethinking the value of that line of business. That's new within the past couple years, as many, many more competitors have shown up in the field and market share is not as easy to come by. It's possible there could be more consolidation, but it's going to run into increased scrutiny by the government.
The S&P/Dow Jones indexes deal got several months of scrutiny, and in the end, they let it happen, but the next one might not be so easy. There's a whole bunch of itty-bitty players that come, go, consolidate—who cares?—but the big ones would likely have a harder time next time around to acquire one of the other major competitors. Nonetheless, scale does matter in the index provider business, and that's a reason for the S&P Dow Jones deal, and that will be the reason for any future combination.
As far as handicapping the players, MSCI is clearly the one to beat. It's on top of the pile now, and they aren't nearly as sleepy and complacent as they once were. They're much more aggressive and looking at the indexing field as part of a larger whole, which is a good strategy, too. Everybody else is going to try to knock them off their perch, but I think they've dug in pretty well.
JOI: What do you think the smaller players—the boutique index providers that have ridden the ETF wave—need to do to survive?
Prestbo: Well, I would sure hate to be them now because what they need primarily is distribution. They don't have anybody else tooting their horn for them as the major index providers do; they don't have established customer bases—people saying, "Well, I always go with so-and-so." That's not happening with these little boutique index providers. The main thing they have to do is broaden their base, but they're trying to do it without any resources and that's a very difficult challenge.
It's easy to know what they have to do. They have to get bigger and more successful. But without people, without budget, I don't see how it's going to happen.
JOI: Where are costs headed for index licensees?
Prestbo: Down. It's the commission story all over again. Down, down, down.
JOI: When an investor is looking at an index-based product, what should they be looking for in the underlying index?
Prestbo: It depends on what they want to accomplish with it, as usual. That's the hard part, and that's the part that people like to skip over because it's hard. You actually have to think. But once you've established what it is you want to accomplish, then you look at the underlying index for representation of that market or market segment. You look to see if the rules are in place to keep it up to date and fresh. Is it once a year? Is it once a quarter? And you look to see if it is—and this is the hard part—solidly conceived and solidly maintained. Some of that you have to infer by looking at who's providing it: S&P, Dow Jones, MSCI, Russell? You infer that there is some muscle behind it. Joe Blow index fund? I don't know.