They were comparing apples and oranges.
Yes. We wanted to do a better job of evaluating whether it was skill or luck that was generating returns for active managers. When we first started, there was a bunch of beta in these guys’ portfolios, and they were getting paid active fees for it. Indexes allowed people to say, for example, “Oh, you just did well in that particular time period because growth stocks did well. I could have put money in a Russell 1000 Growth fund and gotten the same returns.”
Now, I don’t want everybody to be run out of the active business. We need those folks. One way of looking at benchmark index investing is that those investors are free-riders. They get market prices, set by the active people. They take advantage of the fact that smart people out there are trying to outperform, which in turn means they can get reasonable prices when they trade.
In your opinion, how have ETPs changed the indexing industry?
When ETPs first started out, I was a little bit skeptical, especially about the idea of creating an index to make an ETP out of. And personally, I view some of their success as being an artifact of the regulation environment we live in.
In particular, I have to give credit to Rob Arnott. I knew Rob a long time before he came up with his fundamental indexes. When he did, I said, “Rob, you’re just dressing up active management as an index. Don’t call it an index. It’s active management.” But he said, “No, no. It’s an index.” And he kept saying that. And I was saying, “Oh, Rob.”
But then it finally sunk in: One of the reasons you call it an index is so that the SEC will approve it as the basis of an ETF. So what we have now, with all the factors and fundamentally weighted indexes and such, are basically indexes built for the ETF market.
That’s OK, I guess. It’s just a sign of the morphing of the market. For those of us who’ve been at this a long time, we’ve had to adjust to the fact that we’ve got benchmark indexes, we’ve got active management, and now we’ve got these other things that people are calling indexes but are somewhat in between in nature.
Has the growth of smart-beta indexing surprised you at all?
Honestly, I thought it might happen. By the time I left Russell in October 2008, I thought it might happen. I won’t claim I saw it all the way back in 2000, but by 2008 I really did see the signs.
That’s because, for reasons I’m not completely sure make sense, ETFs have become the “sexy” vehicle, at least compared to mutual funds. People were trying to figure out how to get into that market, and so they had to innovate, because going up against the Vanguard S&P 500 ETF (VOO | A-97) is not a recipe for success. So where are you going to go? The natural thing is to choose smart beta, or one of these fundamentally weighted indexes, as a way to compete.
Eventually I think more and more mutual fund companies will launch ETFs, because ETFs appear to be a wrapper that people prefer. So I think a lot of this move to smart beta is associated with the desire to get in on the ETF business. You aren’t going to win the benchmark battle, so instead you do a specialty ETF.
It’s a good way to distinguish yourself from the pack.
Right. Competing with Vanguard on price is not a good way to get rich.
What are some of the big problems in the indexing industry left to be fixed?
I think we need to explore more effective ways to do smart-beta strategies and nonbroad benchmark-based products. I’m not sure what exactly the best way is, but there are a lot of really smart people working on the issue.
Also, I don’t think the current technology that’s being used for leveraged and inverse products will still be the dominant one 10 years from now. That will change. I’m not sure how, but we’ll figure out a better way.