Index Providers Must Now be Proactive By John Spence September 3, 2002

"Innovate Or Evaporate."

That's what it says on the Fortune mouse pad on my desk, compliments of the venerable magazine publisher that also manages a family of equity benchmarks. In light of recent events, other index providers would do well to adopt that slogan.

Many strong upstarts such as Lipper and Morningstar are banking on their powerful brand names to muscle into an indexing business that has been dominated by only a few firms for decades.

More importantly, retail index fund king Vanguard recently set the wheels in motion for a potential switch of some of its biggest index funds over to new MSCI benchmarks under development. In one move, Vanguard has sent a simple but powerful message to index providers: You can be replaced.

This could shake up an index business that has a decidedly academic feel to it. A handful of index providers have leveraged recognizable brand names and collected steady licensing fees since the 1970s.

"Existing popular indexes have enjoyed so much exposure because of their first-mover advantage," said Diane Garnick, global investment strategist at State Street Global Advisors. "However, brand name could become less important as investors get more index savvy and understand the flaws in today's widely-used indexes."

Garnick was recently appointed to a committee of industry experts put together by STOXX Limited, which maintains the European equity Dow Jones/STOXX indexes. Garnick, the only American to be appointed to the eleven-person committee, said the purpose of the group is to facilitate interaction between academic-minded index providers and industry practitioners who manage passive funds.

Such formal arrangements between index providers and passive fund managers should become more commonplace in the future, and index investors stand to gain from the dual search for index best practices. The index construction business is getting more competitive, and customers benefit from increased competition between service providers. Indexes are no longer academic tools for taking the market's pulse; they are now the basis for managing large portfolios.

Shape up or ship out

It appears that Vanguard has two major concerns with the S&P indexes it licenses: incomplete methods for measuring style and excessive turnover. The new MSCI domestic indexes use many variables for measuring growth and value, and also employ a "buffer" or "band" system for determining when stocks move in and out of style and market-cap indexes. The buffer system reduces turnover because adjacent indexes have overlapping boundaries, rather than a definite line in the sand.

It's also hard not to believe that fallout from the licensing dispute between Standard & Poor's and Vanguard didn't motivate Vanguard to contemplate moving away from the S&P indexes. Although Vanguard index fund manager Gus Sauter said the S&P lawsuit had nothing to do with Vanguard's laying the groundwork for switching indexes, some industry analysts have said that the case vexed Vanguard because it feels it has in no small way helped foster the immense popularity the S&P indexes currently enjoy.

Short-term pain vs. long-term gain

Tinkering with indexes that have large sums of investor cash tied to them shouldn't be taken lightly, as evidenced by MSCI's decision to move its benchmarks to free-float weighting last year. The move was necessary because MSCI's weighting system was outdated, and was saddling index investors with excess costs.

Many analysts feared the switch would roil MSCI index funds with turnover, taxes, and front-running by predatory hedge funds. After consulting with passive funds, however, MSCI developed a game plan to manage the switch with minimal pain. In short, MSCI was proactive with its customers. Enacting the changes in a two-step process over the course of the year allowed index fund managers to avoid being front run and to manage the transition at their own pace. By and large, the calamitous losses for indexers predicted by many analysts never materialized, and front-running the rebalance turned out to be a loser's game.

The bottom line is that investors benefit over the long haul from better-designed indexes, despite the turnover that results when a fund switches benchmarks. Vanguard says it isn't bound to adopt the new MSCI indexes, but if it does make the switch it will undoubtedly work hard to minimize turnover and keep front-runners off balance. S&P has indicated it is considering changing some of its methodologies, but one wonders if it isn't too late already.