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 Things are heating up in the index industry. Every day seems to bring a new innovation, a new way of doing things, and new competition. To capture this unique moment in the industry-and to lay out the groundwork for the discussions we'll be having on the pages of this journal over the next twelve months-we invited some of the leading lights of the indexing industry to answer a few questions about the hottest topics du jour. We tried to ask both "establishment" and "innovator" indexers, although in truth, that is a false divide, as some of the most innovative developments these days are coming from the most established names. Some indexers responded by writing, some by phone, and others not at all. The sample is utterly unscientific, but we hope, insightful and thought provoking nonetheless.
Gus Sauter, Vanguard
 George U. "Gus" Sauter is the chief investment officer and a managing director of The Vanguard Group. As chief investment officer, he is responsible for the oversight of approximately $680 billion managed by Vanguard's Fixed Income and quantitative Equity Groups.
Journal of Indexes: What are your thoughts on what the dividing line between indexed and active investing is, if you believe there is one?
Gus Sauter: I think there is a very distinct line. Much like being pregnant, you're either pregnant or your not. You're either indexed or your not.
Indexing really is the concept of getting the market rate of return, or the return from a segment of the market. Anything other than that is laying an active bet against the market or against a segment of the market. All these indexes that are not cap-weighted are making bets against the market or a segment of the market, and those are active bets. It is just like any active manager ... it's just that they have created a rule to apply the active strategy. Still ... they are active bets.
I worry that people are creating very, very volatile indexes, and very, very niche indexes, and that investors could suffer. We believe in broad market indexing and/or using a style-specific index to compliment other holdings. If these highly defined indexes are going to be used as market timing vehicles, I worry that investors will buy near the top and sell near the bottom, as has so frequently happened. It is the Internet craze of this decade.
With the fundamentally weighted indexes, the question is: Do investors really understand what they're getting? They are being told that they are getting an index that will outperform the market. I don't think they understand the potential style bets they're making. They essentially have a value bias and a small-cap bias, and those segments have been running dramatically for the past five or six years. We all know, however, that all styles go out of style, eventually. There's a reason that all the "fundamental indexes" are being introduced today, and not in 1999. Without making a market timing call, my guess is that it is not a good time to be building a position in those indexes. I don't know if we're near the end of the run for small and value, but we're closer to the end than we were in the beginning.
Journal of Indexes: How do you respond to the various challenges to market-cap weighted indexes? Are problems like over-investing in market bubbles and the costs of public reconstitutions/front-running/index effect really problems, or are they blown out of proportion?
Gus Sauter: I think they are largely blown out of proportion. Public reconstitution and front-running could be a bit of an issue in a small cap index, but it is not really much of an issue in a large cap index or a total market index. Some of these articles claiming that billions of dollars a years are lost ... I'm not so sure they have their methodology right. Certainly, the less well-known large cap indexes don't suffer. And I don't think even the S&P 500 suffers from this to any major degree.
A lot of the studies claim that this "index effect" exists by looking at historical data. But it was a very different time during the 1990s, a period that is generally included in the studies. Back then, if S&P announced that a stock would be added to their index, you knew that the stock would go up and up and up. The hedge funds were playing games with it.
But now, hedge funds are amassing such huge inventories of stock around these moves that, when they have to turn around and sell it, their supply is frequently swamping the indexers' demand. The game is largely gone. There are many, many index additions these days where we close on the low for the day.
Journal of Indexes: Any general thoughts on the index industry?
Gus Sauter: We think the big products have been created a long time ago. You need a total U.S. market index, a total international index, a total bond index and a money market fund. And that's it. Those are the formulas that have been making money for people for decades, and we think they will still be making money for people two decades from now. Fads come and go, but not that many people make money from them.
Mark Makepeace and Jerry Moskowitz, FTSE
  Mark Makepeace founded FTSE Group in 1995, and has led its global expansion from the post of CEO ever since.
Jerry Moskowitz is managing director of FTSE Group where he is responsible for increasing FTSE's profile amongst major asset owners, managers and investment banks.
Journal of Indexes: What is your view on the trend toward more targeted and strategically driven indexes or "indexes" now flooding the market?
Moskowitz and Makepeace: Innovation. Innovation. Innovation. Clients are becoming more demanding and want a wider choice of indexes to meet the way they choose to invest. The index calculators are service providers and the winners of the future will be those who can understand and respond to investors needs in the quickest and best way. FTSE won the (William F. Sharpe) awards last year for innovation, but the index business is a marathon, not a sprint race!
Journal of Indexes: What are your thoughts on what the dividing line between indexed and active investing, if you believe there is one?
Moskowitz and Makepeace: What we are seeing is the first phase of "active indexing." There is a clear line between the cap-weighted measure of the market, on which traditional passive index funds will continue to be offered, and a range of indexes that seek to weight stocks on their "true" value. The cap-weighted approach remains the best measure of the valuation the market places on stocks on any given day, but we all know that the market has many pricing anomalies. If it didn't, active management would make no sense!
Now, take the human judgment out of the active management process and select and weight stocks in a structured and systematic way which, in cycles, can outperform the underlying market, and which investors can buy into without the high active management fees. That's "active indexing." It is here to stay and will get stronger and stronger.
Journal of Indexes: How do you respond to the various challenges to market-cap weighted indexes? Are problems like overinvesting in market bubbles and the costs of public reconstitutions/front-running/index effect really problems, or are they blown out of proportion?
Moskowitz and Makepeace: They ARE real problems, but like everything new, the alternatives will have their own drawbacks. Investors need to be cautious in adopting new approaches. Roger Urwin of Watson Wyatts Worldwide suggests to asset owners that they consider dividing their index funds into 50 percent cap-weighted and 50 percent fundamental-weighted. It is good advice.
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