Global Index Group founder and CEO Kelly Haughton has 30 years of indexing experience under his belt. In the 1980s, he created the Russell family of indexes, including the Russell 2000 and the Russell style indexes. He was also responsible for managing Russell’s partnership with the Intercontinental Exchange (ICE), which brought ICE into equity futures trading. In 2003, Haughton received the George F. Russell Jr. Achievement Award for Innovation and Entrepreneurial Leadership. In 2009, he was inducted into the Index Business Association Hall of Fame.
You were one of the great indexing pioneers. Do you think you could launch a new indexing business today and still find the same level of success as when you debuted the Russell Indexes in 1984?
Yes and no. Could somebody launch an indexing business like Russell’s today? The answer is no. At this point, in terms of benchmarking large portfolios, that space is full. What we accomplished at Russell in taking on an entrenched player, the S&P 500, and having a lot of success in doing so, will probably go down as a singular event.
But in terms of producing new products—such as index-based exchange-traded products (ETPs)—I think that, yes, there’s plenty of room for more entrepreneurship.
What do you see as the biggest change in indexing over the past 30 years?
The biggest change in the industry, I think, is its incredible growth. When I first started, indexing was only a small pocket of the general overall investment industry. Now, the London Stock Exchange is buying Russell Investments for its indexing business for $2 billion.
Or consider the Chicago Mercantile Exchange, which felt like it needed to protect its license to trade S&P 500 and Dow futures by essentially buying a position in those index businesses so it can be on both sides of the table. That’s pretty amazing too.
Then you have the International Securities Exchange running an index business itself and working on various ETPs.
Indexing has become big business.
Yes. The mere growth of indexing as a business is very striking. And it’s been a nice ride. There have been so many different evolutions of this industry, and it’s fascinating to see how much it has changed.
Do you think ETFs will continue to be a driver for that growth? Will we get to the point where ETFs will replace, or at least overshadow, mutual funds?
I think ETPs will continue to grow in market share compared to mutual funds for at least another decade. It’s hard for me to foretell exactly what the nature of that growth will be, but I fully expect it will happen. And yes, probably most of those assets will come out of mutual funds.
How much further do you think indexing as an industry has left to grow?
Well, is indexing ever going to be as big as, say, banking? Probably not. But will it ever be competitive with active management? I would argue it already is. Over the last 20 years, indexing has snagged a bigger and bigger market share from active. You could make a pretty good argument that indexing has grown a couple of orders of magnitude, at least over my career. It has become a nontrivial industry.
But there’s a limit to how big indexing’s going to get. I don’t think this industry has another order of magnitude in it. It will not be 10 times its current size 10 years from now.
Speaking of active management, where does it still play a role in investors’ portfolios?
A variety of places. Basically, if you’re an investor who’s willing to tread places nobody else is willing to go, then that’s where you frequently can make outsized returns.
For example, I ran across a hedge fund manager whose primary business strategy was to buy up underwater mortgages, restructure them, and sell them for a profit. I can’t dream of an indexing strategy that would cover that!
So to the extent that we have guys trying to run unusual portfolios like that, I think there will always be niches in the marketplace where hard work and whatnot can result in good returns.
It’s interesting to hear you call active management a “niche” now, especially since, 20 years ago, active was the undisputed king. It was essentially the only way to go.
When we went to develop the Russell Indexes, our primary driver, initially, was to help our consulting clients better evaluate active money managers and figure out which ones were good and which ones weren’t.
Prior to that, everybody had been comparing all active managers against the S&P 500, no matter what their strategy was. So if you had a time period where small-cap outperformed large-cap, then all the small-cap managers would say, “Hey look, we’re beating the S&P 500!” The impetus for us was to be able to say, “That’s a silly comparison.”
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.