In 1896, Charles Dow created the Dow Jones Industrial Average to answer a single question: “What did the markets do today?” By boiling down 12 complex stocks into one simple number, he opened the doors to stock market investing for everyday people.
Decades later, Standard & Poor’s expanded this concept by introducing the S&P 500. Its developers believed they had created a more representative measure of the U.S. stock market by tracking a broader group of companies based on market capitalization. A revolution in investing ensued.
S&P Dow Jones Indices
Today, the S&P 500 is the world’s most followed stock market index with $7.1 trillion in benchmarked assets, at the end of 2013. Its publisher, S&P Dow Jones Indices (S&P DJI), calculates more than 1 million — yes, million — distinct indices on a daily basis. These innovative benchmarks provide everything from vital economic statistics to blueprints for trading a large and growing number of index-based investment products.
“Indices have evolved over the past century from originally serving as measures of the U.S. equity markets to covering an expanded range of asset classes, geographies and investment strategies, and to serving as the basis for investable products like ETFs, mutual funds and derivatives,” says Alex Matturri, CEO of S&P DJI, a joint venture between McGraw Hill Financial and CME Group formed in 2012.
Impressive as the notion of 1 million indices may sound, the success of S&P DJI does not stem from its productivity, but the innovation that goes into conceiving new ideas. Each one requires insight into investors’ changing demands, vision to create opportunities they never knew existed, and skills to transform a concept into an investable market.
“Innovation is the ability to take a problem and find the means of creating solutions that are not just beneficial today but will having staying power for the future,” says David Mazza, whose firm State Street Global Advisors manages $310 billion in Exchange Traded Funds (ETFs) based on indices created by S&P DJI.
“The way S&P DJI constructs its indices, we know they will have great resilience.”
THE INDEXING PHENOMENON
The indexing evolution has been fueled by a powerful movement towards passive investing, which means buying a security whose performance tracks a benchmark rather than paying fees to a money manager who “actively” selects stocks, bonds or other securities. For years, active management was favored by investors and passive investing represented only a tiny sliver of the market.
But the active management strategy rarely pans out. Nearly 61% of all actively managed U.S. domestic equity funds underperformed the S&P Composite 1500 in the five years ending 2013, according to the widely followed S&P Indices Versus Active Funds Scorecard (SPIVA).
Even Warren Buffett — whose legendary investment skills have beaten the S&P 500— questions the merits of stock picking.
“The goal of the nonprofessional should not be to pick winners — neither he nor his ‘helpers’ can do that — but should rather be to own a cross section of businesses that in aggregate are bound to do well. A low-cost S&P 500 index fund will achieve this goal,” Buffett wrote in his 2013 letter to shareholders.
Why does the Oracle of Omaha value index investing so highly? It all goes to the bottom line. Management fees take a significant bite out of returns, according to Vanguard calculations. A $10,000 investment with a 0.26% fee and 6% annual returns (with returns reinvested) will rise to $91,537 in 25 years. Boost that fee to 0.9% and the return drops by nearly $15,000. It’s no wonder the percentage of investments in passively-managed funds has more than doubled since November 2003, according to data compiled from Strategic Insight Simfund and Wells Fargo Securities LLC.
ETFs — securities that track indices but behave like stocks — have further intensified demand. State Street Global Advisors introduced the first U.S. ETF in 1993. It was known as the Standard & Poor’s Depository Receipts (or SPDR, as in an arachnid) and the very first one was called SPY. The product, which tracks the S&P 500, was primarily viewed as a tactical tool for institutional investors.
Standard & Poor’s (then a pre-cursor to S&P DJI) worked with State Street to make SPY friendlier to everyday investors by introducing additional products, like splitting the S&P 500 into nine sector-focused indices.
“The growth was like wildfire,” says Mazza, who serves as Head of Research, SPDR ETFs and SSgA Funds at State Street.
Two decades later, there is roughly $170 billion invested in SPY as of mid-2014, according to ETF.com. Overall, there are 612 ETFs based on S&P DJI’s indices and $719 billion in assets under management, as of June 2014.
“The way S&P and State Street constructed this product laid the foundation for the entire ETF industry,” Mazza says.
More broadly, the proliferation of indices has fostered insights, liquidity, confidence and growth in the capital markets.
WHAT MAKES S&P DJI’S INDEXING INNOVATIVE?
The performance of an index-based investment may not be predicated on Buffett-like brilliance. Yet creating a sound index requires its own dash of genius. The ability to listen carefully to the marketplace is critical.
“S&P DJI is quite good at collaborating with the client and discussing where unmet needs exist,” says Jordan Farris, who develops ETF products for Guggenheim Investments. The portfolio management firm has $15 billion in S&P DJI-benchmarked assets.
“They help discover ways of owning the market in areas in which there’s a void of investible options.”
Once or twice a year, Guggenheim and S&P DJI meet to discuss the general state of the markets. They swap anecdotes and insights gleaned from their day-to-day experiences and then narrow this discussion into product ideas.
At one such brainstorming session, Guggenheim mentioned investors’ inability to effectively differentiate between stocks in the S&P 500 based on their investment strategies of either value or growth. So, S&P DJI helped develop Guggenheim’s Pure Style, a suite of six ETFs that cull the most value or growth-oriented stocks from the S&P 500.
JR RiegerGlobal Head of Fixed Income
S&P Dow Jones Indices
S&P Dow Jones Indices Through similar collaborations, S&P DJI also learned that investors struggle with the structure of bond funds, which don’t provide the two key advantages of buying bonds outright: 1) guaranteed principle at maturity, and 2) stable cash flow from coupons. Yet directly investing in bonds comes with its own set of risks, including hidden costs that can average 1.7% on an individual municipal bond transaction, according to a 2013 S&P DJI study.
JR Rieger, S&P DJI’s Global Head of Fixed Income, created a better option with the S&P AMT-Free Municipal Series 2021. The municipal bond index consists of non-callable bonds that mature within a certain year. Since any investment based on this index will end like a group of diversified bonds, it can be used for time-sensitive financial goals, such as college or retirement. Just as the DVR simplified recording TV shows, this index is an invention that makes life easier.
Alka BanerjeeManaging Director of Strategy and Global Equity Indices
S&P Dow Jones Indices
UNEARTHING GLOBAL OPPORTUNITIES
Fostering close client relationships also helps S&P DJI innovate and serve the needs of global markets. Alka Banerjee, S&P DJI’s Managing Director of Strategy and Global Equity Indices, spends about one-third of the year traveling. Getting out of her New York office allows Banerjee to discover which geographies are ripe for passive investing.
Latin America, for example, may seem like a well-trodden market, yet the combined local exchanges in Peru, Chile, and Colombia had no index to represent this fast growing regional market.
Even better, her regular travels give Banerjee insight into the psyche of local investors.
“South African investors love to have exposure to Pan-African markets,” Banerjee said following a recent trip to South Africa. “While South Africa has a fairly sophisticated community of institutional investors, they do not have standardized regional indices for many of the countries in the African continent.”
In May 2014, this insight led S&P DJI to launch 14 new equity indices covering 13 countries derived from the S&P All Africa Index, bringing the number of new indices S&P DJI launched in Africa in the first half of 2014 alone to 29. This marks the deepest and most extensive suite of indices in Africa, home to many emerging economies, available to investors to date.
In addition to responding to needs, some indices actually create new investors. Muslim investors have historically been alienated from index investing because Shariah law prohibits investing in securities where one does not actually own the underlying asset. To reach this audience, S&P DJI launched its suite of Shariah Indices, with rules-based methodology that adheres to Shariah law. Thus, an entirely new community of investors was born.
In the case of the S&P Healthcare Claims Index, the company unearthed a new way to measure what’s emerging as one the most crucial components of the U.S. economy. Since the introduction of the Affordable Care Act, this index is the first to reflect actual healthcare data from 60 million individuals — roughly 40% of the entire fee-for-service population in the United States.
Jamie FarmerManaging Director of Index Investment Strategy and Data Services
S&P Dow Jones Indices
TRANSFORMING IDEA INTO INDEX
No matter how dazzling a new idea might be, no index can succeed if it does not serve investors’ needs. In today’s choppy market, investors have been particularly focused on low volatility options to smooth out their returns. Many indexers have employed “black box” methods, such as minimum variance, which involves heavy duty mathematics to reduce fluctuations in the entire S&P 500.
But S&P DJI chose a simpler path, narrowing the S&P 500 to its 100 least volatile stocks to create the S&P 500 Low Volatility Index.
“Our approach to indexing low volatility is elegant and much easier to explain,” says Jamie Farmer, Managing Director of Index Investment Strategy and Data Services at S&P DJI.
To be tradable, indices must also possess underlying assets that are liquid enough to be bought or sold at any moment. Highly-leveraged bank loans create a floating rate product that’s enticing to yield-hungry investors, but they’re also difficult to access since many loan facilities cannot be found in the secondary market. The S&P/LSTA U.S. Leveraged Loan 100 responds to this need by selecting the 100 largest loans outstanding, allowing the index to reflect the general market conditions and track loans that represent approximately 25% of the trading volume of the entire loan market.
“S&P DJI is very skilled at creating indices from which we can actually go out and develop investable products,” says Farris, of Guggenheim.
TRUE TO TRANSPARENCY
Most importantly, the nature of an index’s methodology must be transparent to everyone. It is reassuring for an investor to know, at any point in time, what is in an index and how the index chose those underlying assets. The same level of transparency is not found in actively-managed funds, because it may not be immediately clear what that fund is holding or how the management team made its decision.
It has always been S&P DJI’s position that an index should be calculated free and clear of any investment product designed to track that index. Potential conflicts of interest arise when an index, and the investment product tracking it, are managed by the same institution.
“We find great benefits from working with an established partner like S&P DJI,” says Mazza, of State Street. “Their indices have been in existence for a long time with a significant brand name.”
At its heart, benchmarking remains a means of education.
“Indices that we publish should add information for investors to make good decisions about what’s going on in the marketplace or over-the-counter markets. Indices raise investors’ ability to make decisions,” says Rieger.
To that end, the company offers a rich array of unbiased information — webinars, articles and data — on its award-winning website available to anyone free of charge.
WHERE CAN WE GO FROM HERE
Though there are already more than 1 million indices, S&P DJI sees no limit on what it can create.
Institutional investors are discovering new ways to use indices every day. The more familiar with passive investing people become, the more sophisticated their requests. For instance, ETFs based on factor indices (some call them alternative beta ETFs or strategic beta) have gained traction in recent years. In 2013, global strategic beta flows were about $65 billion, which accounted for nearly one-third of global industry flow, according to BlackRock Research. Loosely defined, factor based indices are designed to capture performance characteristics different from traditional cap-weighted benchmarks, such as the S&P 500.
Or, as Farmer of S&P DJI puts it: “It’s indexation that investors paid fund managers to do 10 years ago.”
“Our job is not to guarantee a winning performance, but to try to create a bigger and deeper tool kit for whatever the investor’s thesis,” he says.
That tool kit will need to grow even more. Passive investing may have doubled in the last decade, but index funds and ETFs represent just 26% of total collective assets.
That means there’s plenty of room for growth – and much more opportunity for innovation. S&P DJI’s clients depend on the company for both.
“The appeal of S&P DJI is that they are not just throwing ideas against the proverbial wall,” says Mazza of State Street. “It’s a thoughtful process in figuring out how to bring index returns.”
Amy Kover is a former Fortune staff writer who has written for major publications including The New York Times, SmartMoney, and Real Simple. Her past work can be found atwww.amyrkover.com
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