Tom Nadbielny, the New York-based managing director of Salomon Smith Barney’s global equity index operations, pulls no punches when it comes to index choices for institutional investors’ benchmarking. He takes a somewhat dim view of many of the established names, particularly those offering the worldwide products. “Ten years ago, there were the FT, MSCI and Dow Jones indices. These were quite similar indices in that they were all really portfolios that other people recognise and follow. I think much the same can still be said today.”
In his view, these fall short of being true benchmarks. “Once something gets labelled an index, it gets an aura of authenticity, which it may not have for benchmarking.” He believes many of the indices are excellent commercial products for derivatives or basket trading and are efficient vehicles to this end. “About 90% of the indices out there are tailored to that end of the market.”
Investors, he reckons do not pay enough attention to the fact that they are not designed to meet benchmarking requirements, but lamentably, it is an area which often receives scant investor attention. “People analyse their managers ad infinitum, but when it comes to their benchmarks, they choose the same ones as the guy down the street.”
He asks: “What happens if you have an index that is a portfolio in essence and not designed as a benchmark? Potentially, you are going to have some very large overweightings, in that the index is owning things that are way out of proportion to what investment managers as a whole are owning. You end up with an active portfolio. That is our view of most of the indexes out there.”
The SSB index approach is to require a company to have $100m or more of free float and to weight companies on the index by this float. But float-weighting is not an exact science, Nadbielny readily admits. However, the methodology is to strip out identifiable corporate cross-holdings, large private holdings, government-held shares, and those shares that have legal restrictions resulting in exclusion of foreign investors. “So until Bill Gates puts his Microsoft shares on the market, his proportion will be excluded from our index.”
Such an approach is very straightforward, he maintains, and does not require a committee sitting in judgement about which companies make it to the index. “The decision is made by the market itself.” Given that the purpose of a benchmark is to measure the return within a certain universe, Nadbielny points out that indices can be “all over the place”, citing the 10% difference that can emerge between the S&P 500 and the Dow, to say nothing about the smaller stocks trailing behind. “The world is replete with examples of indices measuring the same things. They may have extremely high correlations, but the returns from them can be extremely different. If investors or managers are being measured by something that does not measure the return of their universe, you are in effect throwing in a random component into their performance measurement, which could be good or a bad, depending on what happens.” This random element is unfair to whoever is being measured, he asserts. “So if they are being measured against an index that says their universe is up 10%, when it is really down 3% and they are at 5%, there will be a huge difference in perception, as to whether they did a good or lousy job.”
Having a family of indices, with the broad global index covering over 8,000 companies across 49 markets, as well as 10 years of consistent data, a great deal of work is being done for US pension plan sponsors in formulating customised benchmarks. “We have a new set of industry classifications, with a structure that can do analysis down to six levels. If an investor wanted to differentiate between Coke bottlers and non-Coke bottlers worldwide we can get down to such specific levels of analysis.”
As US pension plans increasingly differentiate their portfolios, there is a need for more specific benchmarks, which often are a sub-set of the existing indices or can be customised, with back-testing. “Many funds are looking for a small cap index, but then realise that the broad index should be their benchmark. Now we are finding more interest in these questions coming from European investors,” says Nadbielny. Fennell Betson