Frank Russell Co. might make some changes in the construction of its domestic equity growth and value indexes, including creating a separate group of purer style benchmarks.
"We've had a few rumblings here and there about the indexes, that they are perceived to be too `growthy,"' said Mark Hansen, director of global sales and marketing at Tacoma, Wash.-based Russell. Russell's indexes vie with the S&P/BARRA growth and value indexes as the most popular style benchmarks.
Because of the heavy weighting of the technology sector and the addition of lots of initial public offerings, "we may need to take a bigger picture over time," said Lori Richards, index product manager at Russell.
"Last year may have been challenging because of some stocks," she said, referring to, among other things, the recent spate of IPOs.
Russell created an advisory board of users last summer, after its last reconstitution of the indexes, which takes place once a year. One idea it is considering is reconstituting the indexes more frequently.
"That has been a hot topic because of market volatility," said Mr. Hansen.
In addition, Russell is considering creating a set of purer growth and value indexes.
In its existing growth and value indexes, "the method we use for style is reflective of the market. But there are managers who want `purer' indexes. So there is an opportunity for us to provide a suite of pure or deep-value or growth indexes," said Ms. Richards.
That probably won't happen this year. "It depends on demand. We have to make money" on providing them to the marketplace, she said.
A life of their own
Some critics contend the growth and value indexes of both Russell and S&P/BARRA, which are the products of Standard & Poor's Corp., New York, and BARRA Inc., Berkeley, Calif., have taken on a life of their own.
Fueled by fees from proprietary users and licensing for index funds, derivatives and other investment-related products, the style indexes provide a highly skewed picture of the universe of investments, said David E. Tierney, principal with Richards & Tierney Inc., Chicago.
"We've lost sight of what is the purpose of these indexes," he said. "They are becoming proprietary products," rather than benchmarks.
Both David M. Blitzer, chief economist at S&P and chairman of the S&P 500 index committee, which produces the S&P/BARRA growth and value indexes, and officials at Russell denied their indexes were constructed or maintained primarily as revenue-producing products. However, "growth and value (indexes) by themselves are not a huge piece of revenue, but it's a nice chunk," Mr. Blitzer noted. "Clearly it's expensive to do these things."
The Russell indexes "contribute about 2% to the company's revenue," said Mr. Hansen.
Proper index benchmarks, Mr. Tierney said, should be transparent in their methodology, investible and appropriate for the investment process they are measuring.
Russell, for example, "has a proprietary methodology of adjusting shares outstanding by float," he said - that is, eliminating closely held or cross-holding shares. "It becomes their opinion of what the shares outstanding are. That would be fine, but they miss some companies with closely held shares."
"The use of these style indexes is very misleading when evaluating the active management process," he added.
Another critic of the style indexes, Robert D. Barkley, principal and director of client development with Barrow, Hanley, Mewhinney & Strauss Inc., Dallas, accuses the index developers of abusing the idea of benchmarks.
"Many active managers have been terminated because they underperformed the indexes," which don't represent the styles of the managers, he said.
"A true value manager today is going to look substantially different from the value index," he said.
Mr. Blitzer said S&P has no advisory committee of users for its style indexes, such as Russell formed. But "from time to time we hear about individual stocks," he said. "We do hear about the declining number of growth stocks" in the S&P/BARRA growth index.
Under its methodology, the growth and value style indexes must have equal market capitalization. Using only the price-to-book ratio as the criterion, S&P classifies all stocks as either growth or value, putting each exclusively into one or the other of the style indexes. Thus, as growth stocks soared in market value, the growth index contained fewer and fewer stocks, while the value index comprised more stocks. S&P reconstitutes its style indexes twice a year.
Mr. Blitzer dismissed complaints about stocks sometimes switching between growth and value each time S&P reconstitutes its style indexes. "A stock will at times behave as a growth stock or a value stock, depending on its recent fortunes and how it's done against its peers," he said. "We are dealing in shades of gray."
"JDS Uniphase was one we got some comment on," he said.
Messrs. Barkley and Tierney both criticize the addition of JDS Uniphase Corp. to the Standard & Poor's 500 stock index.
When the S&P index committee added the stock to the S&P 500, it did not meet the committee's generally used profitability criterion, which mandates selected companies have at least four quarters of positive operating income, according to a study by Barrow Hanley Mewhinney & Strauss.
According to an analysis by Goldman Sachs & Co., New York, JDS Uniphase had a market value of $99.4 billion when it was added to the index at the close of July 19, the largest-ever market value for an S&P 500 company addition. "Its rank in the index on that day would have been 34," the report noted, which means investors tracking the style indexes would have to add quickly a fairly big chunk of the stock to keep up. "Its addition to the index was similar to the addition of Yahoo!; neither company was in the S&P MidCap 400."
As fast as JDS Uniphase had been growing, S&P/BARRA reclassified it as a value stock in December, along with some other stocks many managers regarded as growth stocks.
"Due to the methodology used to reconstitute the S&P/BARRA growth and value indices, many of the companies long considered growth stocks made their way into the value index," the Barrow Hanley Mewhinney & Strauss analysis noted. "During the latest reconstitution at the end of 2000, the S&P/BARRA value gained 11 stocks in the tech sector, reaching an all-time high of 45 stocks in the index's tech sector. Several stocks, including Broadcom, Sapient, JDS Uniphase, Nortel Networks and Qwest Communication, slid almost unnoticed into the value index."
"An active value manager isn't supposed to hold certain of those stocks" that are in the style index, Mr. Barkley said.
Mr. Blitzer was critical of complaints by value managers.
"For a value manager looking for fallen angels or companies going through rugged periods ... why wouldn't this kind of stock be on their radar screen?
"Stocks that get beaten down should be called value stocks. Looking at that stock (JDS Uniphase) at 40, I'd call it value." The stock was at 31.69 as of Feb. 21, down from its 52-week high of 153.42.
Leaving it to the market
Unlike Russell, S&P isn't planning to change its style indexes or make them "purer," he said. "My guess is the market is in the process of fixing the problems."
"A lot of managers are judged or compensated by how they do against a benchmark," he said. "You have to be careful you don't let managers design the index. Otherwise, if you were to build an index using the same screens as value managers, then it would not be an independent index."
Judy Bednar, president of quantitative management at Northern Trust Investments Inc., Chicago, a major index manager, wasn't so critical of the tracking problem for index managers. "There is no perfect index," she said. Anyway, "it still isn't clear in the market or industry what is a growth or value stock."
In terms of trading, "with large-cap stocks, liquidity is no problem," she said. And with stocks where liquidity is a problem, the index managers might trade several days after the close to add a new stock, trying to avoid a spike in price.
She thinks reconstituting the style indexes more frequently than every six months might lead to more style drift, and certainly to higher turnover.
But Ms. Bednar, who is on the Russell advisory committee, said she would like to see Russell allow more latitude before kicking stocks out of, say, the Russell 1000. She said to lessen turnover, a stock should be allowed to stay in the 1000 index if it hasn't shifted more than a few places below the 1,000 largest in market cap. Right now, "you have an arbitrary cutoff."
But she acknowledged that relaxing the rule in this way would lead to a bias in the construction of the index. "People now know at least what they are getting in the benchmarks," she added.
Russell divides stocks on a non-exclusive basis and only once a year. It uses two criteria for sorting stocks between growth and value: the price-to-book ratio and an IBES Inc. forecast of price. It then places 35% of the stocks as growth and 35% as value. The remaining 30% of the stocks are put in both growth and value indexes in varying proportions, based on a proprietary methodology.
Volatility causes changes
Bard Pope, head of U.S. equity portfolio management at Barclays Global Investors, San Francisco, an index fund manager, said the volatility in the markets has caused a lot of changes in the style indexes.
"A lot of the growth companies have fallen so dramatically they are now value stocks" in the indexes, he said. But, he added, "I don't have any particular problem with the way S&P or Russell reconstitute their indexes." He doesn't want to see either organization change their methodologies. "I don't think you should adapt construction rules for market anomalies."
But he complained about the lack of transparency in some features of the Russell index, such as the algorithms it uses to determine what proportion of some stocks go into both growth and value. "We are talking with Russell about transparency issues," Mr. Pope said.
Mr. Tierney said the numerous changes in the indexes betray a standard these benchmarks are supposed to represent for active managers. "I don't think an investment research department view of the world changes that dramatically."
"Any index should move through time in a smooth fashion," not changing 50 stocks or more at a time, said Thomas M. Richards, a principal at Richards & Tierney. When numerous changes are made to an index at reconstitution, he added, "managers don't take their analysts aside and say, `Don't research these 50 stocks, but research these 50 instead."'