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When is an Index Not an Index?


PHOENIX, Ariz.-Richard A. Ferri, the founder of Portfolio Solutions, spent much of his first day at the Super Bowl of Indexing conference here trying to collect names.

Not for networking purposes. To try and figure out what to call a new category of indexes for stocks and other assets.

The list he came up with was:

* Smart indexes

* Intelligent indexes

* Strategy indexes

* Alternative beta indexes

* Indexing 2.0

* Indexing 3.0

These are indices that do not just try to accurately gauge the "beta"-or average return-of a given capital market, industry sector or style of investing.

These are indices that try to produce "alpha"- above-average returns - by embodying in their rules the tactics pursued by so-called active managers of funds. Managers who seek out stocks and other financial assets that might help their clients' holdings beat the market.

The innovator in this area has been Invesco Powershares, according to Ferri, who moderated a roundtable of index creators and one fund producer-Invesco itself-on the state of the industry.

Invesco licenses indexes to create its more than 120 domestic and international exchange-traded funds. And the goal of all of its ETFs is "to outperform traditional benchmark indexes.''

The PowerShares indexes were launched in 2002. At the time, "traditional benchmark indexes" were used as a performance indicator. Not so much of the underlying stocks, but of managers in the industry. If a fund manager exceeded the benchmark index, he was performing well. If not, not.

More broadly speaking, the indexing-propounded most heavily by the Vanguard Group, now the largest purveyor of mutual funds-also was designed to make investing easy and safe for the couch potato set. Just buy funds that are based on indexes that mirror the performance of the market as a whole or a sector or a style of investing and relax.

Trying instead to build indexes that would outperform the market or a sector or broad performance indicators was a radical idea.

"In this cathedral of indexing, we were probably viewed as the heretic in the church," said Benjamin T. Fulton, managing director of global exchange-traded funds for Invesco Powershares Capital Management.

The idea that actively managed strategies could be embodied in indexes that funds in turn could license and the rapid proliferation of indexes into assets ranging from bonds to options and beyond has made defining what is an index difficult, Ferri contended.

"Everything as an index has caused great confusion among investors,'' he said.

But there are certain salient characteristics that thread through all well-thought out indexes and the funds that license them, said David M. Blitzer, managing director & chairman of the Index Committee at Standard & Poor's Indices.

All indexes are essentially collections of different component securities, whether they are bonds, stocks or other types of assets.

The index creator, Blitzer said, has to be clear about what assets get selected, how they get selected and what they are, at any time. The investing guidelines should be openly available to all investors and the index-and the fund-should have an objective that can be clearly stated.

What an index should not do, is try to forecast the future of any market or security, said Rolf Agather, managing director of research and innovation at Russell Investments.

The indexes should merely carry out the rules that are established and posted. And be designed to provide long-term benefits to investors. Index creators, he said, should not get caught up in delivering a new "flavor of the month," throughout the year.

Right now, he said, a simple distinction can be classifying indexes into two broad categories: benchmark indexes, which reflect the passive approach, and strategy indexes, which reflect the active approach.

Ferri, for his part, worried most about what he called "spindexing": Marketing the active indexes as a way to provide "excess return without taking more risk."

A Denver index creator, for instance, was promoting his concept of an "Iron Butterfly" index at a Standard & Poor's Indices cocktail party on Monday night.

That individual contended funds based on his index would profit regardless of whether an underlying market went up or down. Any time the market moved up or down, noticeably, holdings would be cleared out, profits taken and the fund reset.

The "iron" part is the "guarantee" that the worst an investor putting money into a fund based on his approach could do would be to break even.

Agather said that any index has to prove itself, though, before getting adherence, though. This requires back-testing against historical data or actual live results.

Keeping indexes from proliferating will be hard. Standard & Poor's, for instance, updates 600,000 every night, said Blitzer. Some are created on speculation. Some are used for market analysis. But they all exist.

"We've seen a lot of indices and they don't all get licensed,'' said Blitzer.

Sanjay Arya, SVP at Morningstar, said there will always be "different flavors of indexing" and that even indexes of the same industry sector, for instance, will be approached in different ways by different firms.

"Can the industry ever have a series of standard names?,'' asked Blitzer. "The answer is no. Give up on standard names."