Indices existed well before the launch of indexed financial products. The Dow Jones Industrial Average, e.g., goes back to 1896; the first indexed institutional portfolios appeared in the 1970s, the first index mutual fund in 1976, and the first index-tracking exchange traded funds in the 1990s. In all these cases, the index provider was independent of the provider of the index-linked financial product.
We think that this independence is an under-appreciated aspect of the success and growth of indexed assets. There are three distinct steps that separate the investor from the product:
- Data — price and volume data must first be created (on a securities exchange or otherwise) and aggregated
- Index — using price data and other inputs, an index is created
- Product — an investment product is created by linking to an index
Independent index providers (ourselves prominent among them) occupy only the middle stage of this process.
To see why this is important, consider what happens when the second step is combined with either the first or the third. For an example of why combining the first two steps (data generation and index creation) is undesirable, think of the word “LIBOR.” The LIBOR scandals of the last year were only possible because the same entities controlled both the data and the index. An independent provider would have had the ability to audit and challenge the raw inputs, helping to insure the integrity if the index creation process.
Combining steps two and three can be equally problematic, if less obviously so. When the same entity provides both index and product, how can the end user assess the performance of the index portfolio manager? And how can he know whether index construction decisions are being driven by the best interests of the client or by the commercial interests of the product provider?
Investing in an indexed product without an independent index provider is like playing tennis without a net. It may be good exercise, but it’s not the same game.The posts on this blog are opinions, not advice. Please read our Disclaimers.