A Quick Chat with Indexing Sage Diane Garnick of State Street Global Advisors By John Spence September 16, 2002

"All things to all people is an ideal that usually fails to serve the true needs of those involved. Index investing is no exception to this rule."                             -Diane Garnick, Global Investment Strategist,                              State Street Global Advisors

The staid world of indexing has been shaken up in the past few years by new competition and innovations. We sat down briefly with Diane Garnick to talk about some recent developments in passive investing.

Garnick is the Global Investment Strategist at State Street Global Advisors, where her primary goal is to generate new investment strategies for the plan sponsor community. She moved to State Street in June of 2001 from Merrill Lynch, where she was the director of equity derivatives strategy. Garnick has published reports that cover a wide array of investment topics and is one of the industry's foremost experts on portfolio construction and benchmark selection.

Q: How can existing style indexes be improved?

A: The debate over how to improve the style indexes, sometimes referred to as growth and value indexes, continues as practitioners and academics alike are discovering ways to expand and improve existing theories. Three primary issues are consistently raised, hence index providers would be well served if they focused on these areas.

First, the factors used to classified a stock as growth or value should be more reflective of the investment process used by asset managers. Secondly, the transparency of the indexes must be as clear as possible. All models used to determine a stock's classification should be fully disclosed, with changes updated regularly. Finally, the frequency of rebalancing the style indexes should be carefully examined. The pace of change in the global equity markets suggests that rebalancing on a quarterly basis would result in indexes that more closely reflect the market. To protect investors from excessive turnover, barriers should be created before a company is reclassified.

Q: You seem to think some indexes are good for passive funds, while others are better to judge active manager performance. Are these two qualities mutually exclusive?

A: All things to all people is an ideal that usually fails to serve the true needs of those involved. Index investing is no exception to this rule. Passive strategies require a high level of transparency and liquidity, and low turnover rates. Conversely, active strategies are best served when the opportunity set of stocks is large, providing managers with a deeper pool of stocks to select from.

Q: Could investors benefit from hedge fund index funds or is this an example of the industry taking the indexing concept too far?

A: Hedge fund return data should be relied on with great reluctance. Given the loose regulatory structure of the industry and the innovative strategies that are created almost every day, sufficient data is still not available to create an index that adequately reflects the industry. Investors are still better served by obtaining independent advice as to the risks embedded in hedge funds prior to committing capital.

Q: Some claim that index fund managers are at a disadvantage because their portfolios are transparent. Have index fund managers gotten better at avoiding front-running?

A: The real question is whether the index managers have become better at managing index changes, or if hedge funds have become more skilled at trading index changes. I would argue that the index change strategy that existed for so many years has dissipated as a direct result of the market becoming more and more efficient. We discovered, tested, and then published data and strategies surrounding the now infamous "index effect." The spreads that once existed in the market have tightened, reducing the opportunities for active managers and simultaneously reducing the cost index changes had to passive investors.