Straight From The Source: John Prestbo

August 30, 2007 talks with John Prestbo, editor and executive director of Dow Jones Indexes.

Index Universe recently met with John Prestbo, editor and executive director of Dow Jones Indexes, to discuss the current state of the indexing industry, the rise of ETFs and new ETNs, the current chaos in the stock market and the future of Dow Jones Indexes.


Index Universe: What has been the most notable change in the indexing industry over the years?

Prestbo: I think it's the pace. When Dow Jones decided to make indexes a business unit it was a pretty sleepy community that we were joining. The players in it were S&P and Russell and FTSE and MSCI, and they'd been in for a while. They were kind of used to doing things their way, and it took a while to change anything that they were doing. Then we came along, Dow Jones Indexes, and our first business strategy was to license indexes for financial products. Now this happened to coincide with the realization that ETFs were kind of neat, and so we've benefited a great deal from the growth in that particular vehicle. Now, of course, practically everybody and his brother is an index provider, and competition is fierce.

Index Universe: Have any indexes from the up-and-coming index providers caught your eye?

Prestbo: Oh, yes. I think those Intellidex indexes are interesting. I even think that Rob Arnott's RAFI is interesting. But index ideas are kind of a dime a dozen. It's the difference between idea and concept, and I think that's an important distinction. It's also the difference between idea and execution. I think a lot of stuff gets created in a hurry because it looks good in back testing, and it gets thrown out there into the marketplace. Then, as they rush off to do something else, what they've created doesn't have any life of its own -- it doesn't have a reason to exist for investors, particularly. So that's one of the downsides of all this competition.

Index Universe: What is the most pressing issue facing the indexing industry?

Prestbo: Certainly the one that has the most ink spilled because of it is the ongoing debate about standard market cap indexes and so-called fundamental indexes that really consist of two variations: One is a different kind of selection methodology, the process whereby components are selected, and the other is how they are weighted, the weighting methodology. And the question is, are these really indexes?

Well, yes, they really are indexes, but are they the kind of thing that John Bogle had in mind when he created the first index fund? No, they're not. I think people have become confused -- that the concept of indexing, which is investing passively, has been equated with these other indexes that are anything but passive. In fact, they're quite active. Even choosing one as an ETF to put your money into is active investing.

I think there's a lot of semantic problems here, or maybe too few words to distinguish different things that not many years ago meant the same thing but don't any longer. So I think it can become an issue for the industry if one of these things blows up and indexing gets a black eye, because they're not the same thing.

I've talked to several people in the business about this, and the best we can come up with is that index providers ought to be very clear about what they're offering, and hopefully financial advisors and brokers will pick up on that and be able to counsel their clients to make wise choices. Because indexing as an investment strategy has got a lot going for it -- just ask Bogle, and he'll bend your ear for an hour or two. It would be a shame if that kind of investing, which suits a lot of people very, very well, suffered anything if some of these crazy little index funds go haywire.

Index Universe: Why all the newfound interest in screened indexes like the Shariah indexes?

Prestbo: I think this very populous religion of Islam is going to become an investment force at some point down the road. And it's one of the few faiths with precepts that govern the kinds of investments you can make.

Faith-based investing and sustainability investing, or socially responsible investing, are coming to the fore much more than they have been and with better reputations than they used to have. It used to be, "Socially responsible investing? That will knock about 5 percentage points off your return." Well, not anymore, and not with the new indexes, and not with the new awareness that I think people around the world now have for the environment and for things like exploitive child labor. So that's a trend.

Index Universe: What about all the new non-traditional sector funds? Indexes focused on nuclear energy or renewable energy or the like?

Prestbo: They may be outside the norm now, but they'll be inside the norm very quickly. I mean, there are two things going on here -- one is the ETF boom, which has required thinner and thinner slices of the market in order to keep coming up with something new. And to a certain degree those ETFs are helpful for investors who want to actively manage their exposures to sectors or parts of sectors or whatever. But then the bologna can get sliced pretty thin and you can read through it, and you wonder what possible investment purpose this can have.

But things like alternative energy are hot items at the moment, and if there are breakthroughs in something like hydrogen fuel cells or even more efficient solar panels or something like that, companies innovating their way to that kind of achievement will be red hot in the stock market. So I think that we have to make room in our classification systems for these kinds of things.

Index Universe: Do you think ETF assets will eventually rival traditional mutual fund assets?

Prestbo: Well, if they create enough of them, they might. There haven't been that many mutual funds created since ETFs really got rolling, so it's clear that there is a competitive situation here between the two kinds of instruments. It's just that the two appeal to different kinds of investors.

Mutual funds are great for the man or woman or family that puts aside 100 bucks a month or something and just stashes it into a mutual fund. If you did that with an ETF, your brokerage cost would eat you alive, even with the online brokers. So ETFs are good for trading, which of course drives John Bogle nuts because you're not supposed to trade in his world. But it does allow for somewhat quicker adjustment to changing market conditions and, as you may have noticed, things are happening faster and faster in the markets as we push into the 21st century. So speed and convenience are probably going to become more valued attributes for instruments in the future. But I think there will always be a place for the old-fashioned mutual fund, because I think it's most suitable for certain kinds of investors.


Index Universe: Do you think ETNs have the same potential as ETFs? You don't have to worry about the fund management, just the stability of the issuer.

Prestbo: Well, the stability of the issuer, yes, and we still haven't heard from the IRS as to whether these things are up to snuff as far as the tax collectors are concerned. The difference of course with an ETN is that there's no "there" there. In other words, the note doesn't act like a fund and hold real assets such as commodities or the whatever -- it's just a swap contract. And swap contracts, which are how the issuing bank hedges its exposure to these notes that it has issued, are all derivatives. Well, who knows where that swap ends up? And as we've seen by the recent meltdown from subprime loans, once something turns bad and it's widely held, it can snowball through the markets something fierce. So all of that is by way of saying that no, I don't think ETNs are going to make as big a splash as ETFs.

I think they're convenient for certain kinds of assets that are not easily held by ordinary investors, like commodities, perhaps. And I think they're a vehicle that might provide some exposure to asset classes that simply have not been securitized up to this point, but I think it's going to continue to be an exotic part of the garden.

Index Universe: You were talking about how things are getting faster and faster in the markets. Is speed basically going to be just a new way of life with the stock market?

Prestbo: This latest uproar will settle down sooner or later. What I was talking about was manifest though these past few weeks in the rapidity with which the markets reacted to developments. Markets are the same old thing we've known and loved for all these years. In other words, they oversell and they overbuy, and they swing too far, and they adjust, and all that -- it's just happening faster.

Say you're in a position where you're kind of at the end of your working life and you still would like to accumulate more dollars, you want to be in some risky stuff to accumulate those dollars. But then you are worried about downturns that will erode your capital, so you want to be able to adjust, and pretty much on a dime. So that speed is going to be a factor. The pace of change of almost everything in our lives is speeding up, and markets simply are not any exception to that. Plus, with all the computerization, you're able to do it faster. You don't have to pick up a phone and call your broker anymore. You can, but why? You can just do it online and very quickly.

Index Universe: Is the recent volatility all part and parcel of that increasing speed?

Prestbo: No, volatility is a sign of the pull and tug between greed and fear. When that pull and tug gets real tense, volatility goes up. In the big bull market of the '90s, there were periods there when the market was hitting one record after another but the volatility was very low, because there wasn't a lot of disagreement among people which way the market was going. Obviously that changed as the bubble blew up to its fullest extent and then popped, and then volatility set in. Volatility is the result of deeply held different opinions about what's going to happen next. That will never go away. But it won't be constant either, it comes and goes.

Index Universe: Where do you see Dow Jones indexes going in the future?

Prestbo: Well, on to glory. We just finished our annual strategy meeting, preparing for the 2008 budgets, and so on. And there was some exciting stuff there that was discussed about ideas and relationships with other parties and so forth that, to me, indicate a great deal of potential lies ahead. We're firing on all cylinders trying to get as much of that done as we possibly can. I see the index business, and our part of it, growing strongly, and I don't see any end in sight. And I'm really happy to say that, because that pays my salary.

Some people have wondered if when News Corp. assumes control of Dow Jones whether that will have any impact on indexes. I don't think so. I believe Mr. Murdoch is on record as saying he wants it to keep growing. And we're here to help do just that.


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