Product and Strategy Notes: More Active Index ETFs, Planners vs. Brokers, New Morningstar Index Funds, Index Reconstruction Losses and Why No Ads for Index Investor?

Still More "Active Index" ETFs Launched

In our June, 2004 issue we wrote about the growing phenomenon of "active indexing." One aspect of this was the introduction of so-called "index funds" that track an "index" that itself represents nothing more or less than the results achieved through the consistent (i.e., mechanical) application of an active investment management strategy. This trend recently received a large boost when PowerShares registered twenty-five new "active index" ETF products with the U.S. Securities and Exchange Commission. They will cover not only the usual categories (e.g., six Large, Mid, and Small Cap growth and value ETFs, and sixteen industry sector ETFs), but also some new ones, including the Value Line Timeliness and Safety Index, a high dividend paying companies index, a China Index, and a large companies index published by Zacks. We repeat what we wrote in June about this phenomenon: from our perspective, it is not indexing at all, but rather active management, with all the advantages and disadvantages that implies. And also with one new disadvantage (at least for ETFs): the PowerShares ETFs are structured to include the payment of a 2% front-end load by investors. While this will no doubt make these products more attractive to brokers to sell to their (unsuspecting) customers, it certainly won't help those customers' returns. In sum, caveat emptor!

Planners and Brokers Head to Court

Once upon a time, there were two different businesses. Securities brokers accepted customers' orders to buy and sell securities. They legally acted as their customers' agents and charged them commissions to execute these transactions. In contrast, investment advisers provided investment advice to their clients. They typically charged their client a fee for their services (e.g., calculated on a per hour basis or as a percentage of the value of their client's assets). Under the Investment Advisers Act of 1940, they had a clear fiduciary duty to put the client's interest above the interests of their own firms. In the 1990s, however, two big changes came along. With the future of Social Security looking increasingly doubtful, and many employers shifting from defined benefit to defined contribution pension plans, many more people were seeking advice about how to invest their savings. At the same time, traditional brokers found their revenues under pressure from new entrants into their business (so called "discount brokers"), who offered customers far fewer services but charged them much lower commissions. As a result of these changes, the traditional brokers' business suffered, while the advisers' business boomed. Naturally, this didn't sit too well with the traditional brokers. So they decided to enter the advisers' business. They started calling their stockbrokers "financial consultants" or "financial advisers." They also started to offer their customers pricing plans that charged fees based on the value of customer assets held in their newly renamed "investment accounts", rather than traditional commissions. Finally, in 1999 they went to the regulatory authorities (the Securities and Exchange Commission) and received an exemption from the Investment Advisers Act of 1940. The brokers convinced the SEC to issue a "proposed rule" that let them look like a duck and quack like a duck, without being regulated like a duck. This ruling enabled them to avoid having their brokers held to the higher fiduciary standards under which Registered Investment Advisers must operate. The key provisions of this very strange ruling were that any investment advice provided by brokers to their customers had to be "purely incidental to the provision of brokerage services" and that customers had to be informed that their accounts with the broker were still, in legal terms, brokerage accounts. Despite many protests (e.g, from the Consumers Federation of America), the SEC began to enforce the proposed rule, even though it was never formally adopted. Needless to say, the new rules have allowed brokers to attract a large amount of new customer assets into the "investment accounts" offered by their "financial consultants." Naturally enough, this has rather miffed the financial planning industry, which believes that all ducks should be regulated as ducks under the Investment Advisers Act of 1940. So this past month, after five years of fruitless lobbying, the Financial Planning Association sued the SEC to help bring this about. And what do you know? The SEC reopened the comment period for the "proposed" rule. Now we're getting somewhere.

New Morningstar Index Funds

Last month, nine new exchange traded funds that track the Morningstar size and style indexes started trading on the New York Stock Exchange. The nine funds are based on Morningstar’s familiar size (large, mid and small cap) by style (growth, core, and value) index matrix.

The current index products that the Morningstar funds most resemble are those from Dow Jones. As we have written before, there are basically two ways to construct an index: you can fix the number of stocks it contains, or you can fix the percentage of total market capitalization that it covers. Both Morningstar and Dow Jones take the latter approach. The Morningstar U.S. Market Index (upon which the nine size/style box funds are based) covers 97% of total U.S. public equity market capitalization, while the Dow Jones U.S. Total Market Index covers 95%. In 2003, the return on the Morningstar U.S. Market Index was 30.73%, while the return on the Dow Jones Total Market Index was 30.75%.

In both cases, "large cap" refers to the top 70% of the total market capitalization, and "mid-cap" refers to the next 20%. However, for Morningstar, "small cap" refers to the next 7% of market capitalization (i.e., it excludes the bottom 3% of the market), while for Dow Jones it refers to the next 5%. In contrast to these indexes, the Wilshire 5000 Index covers 100% of the market capitalization of the U.S. public equity market.

Both Morningstar and Dow Jones use a factor model to classify stocks into the "growth" and "value" styles. Morningstar’s model uses ten factors, while Dow Jones’ uses six. Unlike other index providers, both Morningstar and Dow Jones exclude some stocks from their respective growth and value indexes if they are not a sufficiently good fit with either one. Morningstar assigns these stocks to its "core" style category. Dow Jones does not have a similar style category for the stocks it excludes from growth and value. The style classification approach used by both Morningstar and Dow Jones should produce a greater difference between the returns on the growth and value funds, and thus be more attractive to style-based investors.

The following table compares the 2003 returns on the Morningstar and Dow Jones size/style indexes:

As you can see, in 2003 the Morningstar approach produced higher returns than the Dow Jones approach within each style category. However, when it comes to the cross-style difference in returns within each size category (e.g., Large Growth less Large Value), Morningstar produced a larger return difference only in large caps, while Dow Jones produced a larger return difference in small caps.

Finally, comparing their expenses, the exchange traded funds that track the Dow Jones indexes are five basis points cheaper than those that track the Morningstar indexes. The former’s large cap ETFs carry annual expense loads of .20%, while the latter’s charge .25%. Dow Jones' small cap ETFs charge .25% per year, while Morningstar’s charge .30%.
On balance, both the Morningstar and Dow Jones offerings are solid products. However, the former’s size/style classification approach seems marginally more attractive, and, if 2003 is any guide to the long-term, worth the additional five basis points in annual expense charged on the Morningstar ETFs.

How Big Are Index Reconstitution Losses?

We occasionally hear the assertion that "index reconstitution effects" somehow negate the case for indexing. Let's look at this argument in more detail. First, what is "index reconstitution?" It is when the provider of an index changes the companies that it contains, forcing index funds to make adjustments in the securities they hold. Because these changes are announced in advance, they provide an opportunity for actively managed funds to profit at index funds' expense. The former can purchase the new additions immediately after they are announced, while the latter have to wait until they become effective, in order to minimize tracking error versus their target index. In the paper "Pre-Announced Index Changes and Losses to Investors in S&P 500 and Russell 2000 Index Funds", Chen, Noranha and Singal find that reconstitution effects cost investors in the former 0.10% annually, and investors in the latter a much larger 1.84% annually. In another paper, "The Price Response to S&P 500 Index Additions and Deletions" the same authors note that the response to changes in the index isn't symmetric. Companies added to the index usually see their returns increase by a larger amount than those dropped see theirs decline. Another paper by Denis, McConnell, Ovtchinnikov and Yu finds that a company's addition to an index apparently provides new information to investors, which in turn may explain the asymmetric price response.

A key point with respect to the .10% and 1.84% reconstitution cost estimates is that they are based on a fund that simply replicates the companies in the index. In point of fact, most index funds employ a range of strategies to reduce these reconstitution costs (e.g., using sampling rather than replication to construct their portfolios). Finally, the index providers are well aware of the problems caused by reconstitution, and have recently taken steps to limit them, including the move to free float index weighting, as well as the institution of buffer zones between, for example, large, mid and small cap indices in the same family. In sum, we don't see the existence of reconstitution costs -- which are declining -- as having much of a negative effect on the overall case for index investing.

Why We Don't Accept Advertising.

When we started The Index Investor in 1997, one of our role models was Cooks Illustrated Magazine, which accepts no advertising, and is entirely supported by subscription revenue. As readers, we always admired Cook's objectivity, and the sense that it was writing for us and not to keep its advertisers happy. A recently published working paper, "Do Ads Influence Editors? Advertising and Bias in the Financial Media" by Reuter and Zitzewitz confirms that our instincts were right on target. The authors of this paper evaluate the impact of advertising revenues on the mutual fund recommendations made by Kiplingers Personal Finance, Money Magazine, and Smart Money (all magazines), and by the New York Times and the Wall Street Journal newspapers between 1996 and 2002. They find that "the [mutual fund] recommendations of these publications have an economically significant impact on investor flows but little ability to predict future returns." Specifically, the authors estimate that "a single positive media mention for a fund is associated with inflows ranging from 10 to 26 percent of its assets over the following 12 months." Unfortunately, they also find "evidence of a positive correlation between who has advertised in a publication over the prior 12 months and who receives positive media mentions for all three personal finance magazines in [their] sample, but not [thankfully!] for either national newspaper." The authors conclude that "if we interpret this correlation causally, a non-trivial share of [a fund company's] return to advertising in a personal finance magazine comes via biased [fund] recommendations." You'll be happy to know we're sticking with our subscription-based approach!

| Model Portfolio Update | Research Roundup: Making the Case for Active Management | This Month's Letter to the Editor: Asset Allocation - Terrorist Attacks and Catastrophic Occurence | Global Asset Class Returns | Product and Strategy Notes: More Active Index ETFs, Planners vs. Brokers, New Morningstar Index Funds, Index Reconstruction Losses and Why No Ads for Index Investor? | Equity Market Valuation Update |