Benchmarks do make a difference.
In recent Pensions & Investments commentaries, James H. Furey of J.P. Morgan Securities Inc. argued that the S&P Small Cap 600 is a better benchmark than the Russell 2000 (Dec. 10); and Andy Turner of Russell Investment Group replied that Standard & Poor's approach to benchmarks is inferior because its indexes are managed by committees instead of chosen by a rule book and "the market" (Feb. 4). Mr. Furey's case is based on better performance for the S&P Small Cap 600, better liquidity among its stocks and less disruption in the markets when changes are made. Mr. Turner doesn't like the idea that a committee of senior S&P market professionals is managing the S&P Small Cap 600 instead of simply choosing stocks once a year, based on their market caps. Both more or less agree on the numbers - that the S&P 600 performed better than the Russell 2000 from 1994 through 2001, and that when stocks are added to the S&P 600 they pop less, on average, than when stocks are added to the Russell 2000.
S&P did not set out to produce a small-cap benchmark that would beat the Russell 2000. Nor did S&P many years ago set out to create, in the S&P 500, a benchmark that would outperform two-thirds of the active managers in most years. Nevertheless, that has been the result. The benchmark does not define the universe from which managers choose stocks. Since some investors use the index through mutual funds, exchange-traded funds and other investment products, fewer stocks and liquid stocks mean more efficiency and lower trading costs. A good benchmark should be fair - if a manager can't buy the stocks in the benchmark and achieve the benchmark's performance, he shouldn't be judged by it. Looking at the BGI iShares for the S&P Small Cap 600 and Russell 2000 over the last year, both indexes achieve this goal. However, fairness also means that all investors have access to critical information on an equal footing. S&P believes that its guidelines, publication policies and its index committee do a very good job.
One key reason for benchmarks is "the evaluation and selection of money managers," as Mr. Turner describes Russell's core business. Managing benchmarks, like managing money, is a full-time job, not something that should be done once a year with a listing of companies by size. S&P's experience suggests that a group of professionals who review the index to assure that it reflects the market and meets its published criteria is the best way of providing fair benchmarks to plan sponsors, money managers and the investing public.
From time to time, the idea arises that rules and benchmarks should be set by dispassionate computers instead of fallible humans. Surely at the dawn of the 21st century, debaters say, we can do better than having people determine what good investment performance means. Evidence proves otherwise. Moreover, the S&P and Russell indexes both were conceived and developed by people. When the market takes an unexpected turn, when investment bankers create a corporate structure or some other new wrinkle, or when questions arise that the index rules can't answer, people must decide what to do. These are not always rare or arcane questions. Plan sponsors and money managers should recognize that both S&P and Russell offer indexes that are run by people, not by some mystical market computer. What differs is the approach used by the people at S&P, compared with the approach used by the people at Russell.
S&P publishes the guidelines it uses in selecting stocks and the index membership and share-counts used in calculating its indexes, and it issues announcements, as material information, on index changes to all investors at the same time. Russell restricts some of the data to its clients, including the list of index additions. However, the goal of transparency is to make the playing field level, so some investors don't have a better chance of beating the index or front-running the changes. Ironically, Russell's procedures set off months of analysis, second-guessing and trading in the weeks leading up to its annual rebalancing. In S&P's case, because there is no one grand moment of annual turnover and because the critical information - additions and deletions - are published for everyone, there is less risk of game-playing.
The S&P index committee talks to the media and to investors, meets with companies when they are involved in mergers, spin-offs or other structural changes, and invites comments from the financial community. Last summer, as part of a review of whether real estate investment trusts should be included in its U.S. indexes, S&P received comments from money managers, plan sponsors, REIT analysts and others.
The committee recognizes that the indexes are used by numerous investors and that S&P has a responsibility to help inform these investors.
David M. Blitzer is managing director and chairman of the index committee at Standard & Poor's, New York.