Not So Fast

November 01, 2006

The storm clouds are gathering over "Indexland." The Second District Court of New York's ruling in Dow Jones & Co. Inc. v. International Securities Exchange Inc., found that the International Securities Exchange (ISE) could list and trade options on exchange-traded funds (ETFs) that track the Dow Jones Industrial Average and S&P 500 Index without entering into a licensing agreement with the designers of those indexes.

As Jonathan Mazer and Alison M. Rende explain in their in-depth analysis in this issue of the Journal of Indexes ("Going, Going, Gone," page 10), the court's ruling goes beyond the issue of ETF options and questions the very idea that index providers have the right to license their indexes for financial products. Mazer and Rende speculate that current trends in case law suggest that someday, perhaps soon, product developers will claim the right to launch index-based products without paying the index developers a red cent.

Mazer and Rende lay out a strong argument, but ultimately, I think they overreach: While case law may be chipping away at the intellectual property claims of index providers, their core right to control and profit from the fruits of their labor is too fundamental to be tossed aside on the whim of legal technicalities.

Some may argue that I'm biased. I launched my career in the index industry. In fact, I worked on the committee that put together the S&P 500, the very index that sits at the heart of one-half of the ISE lawsuit. My experience in "Indexland"- by which I mean all the parties involved in the creation and distribution of indexes, the creation of products and services based on those indexes and the use of both the indexes and the products and services by market participants- convinces me that, in the end, the indexers' right to profit from their labor is as solid as ever.

Fast Growth ... For A Reason

The index industry has been expanding at a furious rate in recent years. Investors' appetite for index-linked products has grown exponentially, and index designers have continued to innovate in an attempt to stay one step ahead of this s u rging demand. There are more indexes and index-linked products than ever before. Recently, we've seen the advent of so-called "active" indexes, a virtual oxy moron, but an oxymoron that has attracted billions of dollars in assets, and that some intellectuals have called the newest "paradigm" in financial theory.

The earliest indexes, of course, were developed before index funds even existed. Interestingly, the index industry is still dominated by the old-line firms that created these first indexes, including Dow Jones, Standard & Poor's, FTSE, MSCI and Russell.

One unique - and not coincidental - feature of these old-line index companies is that they are all subsidiaries of larger parents: S&P is part of McGraw-Hill, Dow Jones Indexes is part of the much broader Dow Jones & Co. (publisher of, among other things, The Wall Street Journal), Russell indexes is an offshoot of Russell's asset management company, etc.

This "parent company" syndrome is no accident. Indexes were originally created in large part to serve as public relations and marketing instruments, aimed at raising the profile of larger businesses. The people who would strip index providers of their rights want to turn back the clock to this earlier, "purer" age, when men were men and indexes were developed for indexes' sake.

But the idea that indexes were created solely as PR tools is a myth. From the earliest stages of the industry, indexes were also thought of as potential sources of profit for their parent companies.

I started working at S&P in 1973, when the first index funds were just being developed and tested. At the time, index operations at the two major index providers, Dow Jones and S&P, were nothing more than an intense number-crunching exercise to support the rudimentary computer calculations of the era. Wall Street research was the prime beneficiary, using the basic index values and ancillary financial index calculations to work out stock peer group ratings, portfolio management and performance measurement tasks.

Then along came index funds, and in the 1980s, index futures and a plethora of index products. These new products created new streams of wealth for index developers, and not surprisingly, spurred lawsuits; specifically, Standard & Poor's v. Commodity Exchange Inc. and The Board of Trade of the City of Chicago v. Dow Jones & Company Inc. These two landmark rulings established the generally accepted practice that indexes were intellectual property to be licensed as the basis for index products.

In our free market economy, that seems like a basic right: the right to profit from the fruits of your labor.

Hard Work

How, then, has that right come under threat? In part, I think it is because of a common misconception that indexes don't really involve any labor; that they just "are," and don't require much effort. You just sit down over lunch, punch a few keystrokes into an Excel spreadsheet and-presto!-the nouveau index. Right?

Not quite.

In my experience, the hardest part of creating an index is developing the "stated purpose," which is the philosophy and guiding principle for the index calculation, management and methodology. This takes time and intellectual input, and involves testing and research.

Once this stated purpose is determined, the actual methodology is developed and tested again through the creation of a simulated back-history, to see if the stated purpose is achieved. Once approved, the methodology, or "blueprint," is sent to the index "factory" for production. This involves a labor- and technology-intensive exercise to check, recheck and cleanse raw data for input into the calculation process. The data output is then packaged and released into the world in various formats and at various prices, just as any other factory product is distributed and sold by its manufacturer. Quality checks and redundancy in systems are also typical for most major indexers, leading to greater value-added, a better and more consistent final product, and higher costs to the index provider.


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