Russell caffeinates index war aimed at Standard & Poor’s

Russell Investment Group earlier sent half-pound bags of Starbucks coffee to 300 of its favorite institutional investors, but the added caffeine is not likely to send those investors flocking to Russell's indexes.

The coffee giveaway is part of the Tacoma, Wash.-based firm's new marketing campaign, aimed squarely at its long-time nemesis, Standard & Poor's, New York. Russell used the gimmick to highlight differences in how the two groups set their indexes. Starbucks entered the large-cap Russell 1000 index in 1993, but only joined the S&P 500 index in 2000.

Investment consultants acknowledge that Russell's method of recalculating its indexes every year is preferable to S&P's refining by committee, but they also said institutional investors and their money managers are likely to stick with S&P as their benchmark and investible indexes for large-cap portfolios.

"Over time, it'll probably be pretty close" in terms of which firm has the most market share, said Chris Meyer, a managing principal and chief investment officer at Fund Evaluation Group, Cincinnati, an investment consulting firm. "Managers will probably go back and forth."

At stake is more than just prestige.

More than $1.2 trillion is directly indexed to S&P indexes through mutual funds, ETFs and direct portfolios. For Russell, the number is $327 billion.

In addition, futures and options trading on the firms' indexes is huge. In June alone, 14.9 million futures contracts based on S&P indexes and 1.7 million contracts based on Russell measures traded at the Chicago Mercantile Exchange. At the Chicago Board Options Exchange, more than 7.7 million options on S&P indexes traded in June while nearly 61,000 options on Russell indexes traded.

In the fast-growing world of exchange-traded funds, the numbers are also large. At the CBOE in June, more than 76,000 options contracts on S&P-based ETFs traded while about 22,500 options on Russell-based ETFs traded.

The battle for institutional investors also is critical to Wilshire Associates Inc., Santa Monica, Calif., and Dow Jones & Co., New York, which recently combined forces on their index products. They, as well as Russell and S&P, seek to create products that investment banks will be eager to license and create derivatives around — futures and options mainly. The investment banks then sell those products to institutional investors and their money managers.

"When it comes to business and profitability, the majority of S&P index revenue comes from tradable indexes," said David Blitzer, chairman of the S&P Index Committees, the groups that decide changes to the S&P indexes. "But that does not mean that the benchmarks are not profitable. For S&P, our index business stands on its own two feet. It's a business we pay attention to."

David Grieger, Russell's director of marketing, said indexes for benchmarking and investing go hand in hand.

"The more you have people looking at those (indexes) as benchmarks, that leads to volumes in the derivatives marketplace," he said. "We created the Russell 2000 to evaluate small-cap managers and volume in (Russell 2000) derivatives has risen."

He said derivatives based on the large-cap Russell 1000 and broad-market Russell 3000 are less liquid but "still active."

Keith Hocter, a consultant with Bellwether Consulting LLC, Cedar Grove, N.J., said since derivatives based on S&P products — most notably the S&P 500 index — have been around for a long time, they are less expensive for money managers to use, making them more attractive.

"The argument for a long time is that the futures and swaps markets for S&P, especially the S&P 500, are more developed and so you can run a little cheaper with them," he said. "Over time, that distinction has gotten smaller, though it's still there. You can probably run an S&P 500 strategy cheaper than a Russell 1000 strategy."

Fund Evaluation Group's Mr. Meyer said that in the last 10 years, the Russell 1000 index and the S&P 500 index — both companies' main large-cap market indexes — have largely performed equally. He added that because most portfolio managers are not pure growth or pure value managers, many prefer Russell style indexes because they are not as rigid as the S&P ones.

"When it comes to style indexes, managers prefer Russell over S&P, but for large cap they prefer S&P because it's been around longer," Mr. Meyer said.

The battleground for institutional investors is centered on the big, well-known indexes. Russell's new advertising campaign, dubbed "Follow the leader," highlights the fact that its benchmark Russell 1000 included several of today's blue chips — Microsoft Corp., Starbucks and Amazon.com Inc. — long before the S&P 500. In fact, Amazon is still not in the S&P 500.

"This campaign is targeted toward the institutional investor," said Russell's Mr. Grieger. "What we wanted to do is use this season — June is the time we refresh the indexes — to highlight the virtues of the Russell index family."

He declined to say how much Russell was spending on the advertising and marketing program, which is scheduled to run through the summer and includes advertisements in trade publications such as Pensions & Investments as well as a highly targeted direct mail campaign.

Lynn Cohn, a spokeswoman at S&P, said her firm launched a new advertising campaign around its indexes about four months ago and has no plans to react directly to the Russell campaign.

In its advertising campaign, Russell makes note of its annual reconstitution, in which the company reviews the top 3,000 capitalized stocks and makes additions and subtractions.

"Once a year we let the market tell us which companies should be in the index and which should be moved out," Mr. Grieger said. "We think that is the right way to do it."

Gregg Buckalew, senior vice president and head of the investment consulting practice at Clark Consulting in Atlanta, said, however, that index creation and reconstitution are areas in which the index companies have fallen short.

"A market index really should represent the pool of securities that active managers draw from," he said. "Traditional index builders have not done a great job with that and a lot is due to the technology that limited their capabilities."

He said relatively new U.S. market indexes created by Morgan Stanley Capital International Inc., New York, appear to have tackled that problem.

"They've taken advantage of technology to put in a structural means for avoiding bias and really coming up with the pure objective for a market benchmark index," he said. "So it's a pool of securities that really does replicate what active managers are drawing from. They developed the capability in the '90s not only to construct indexes but operate them on a real-time basis," which helps avoid major disturbances around reconstituting the indexes.

MSCI, which is a leader in global securities indexes, launched its U.S. indexes last year and quickly lured mutual fund giant Vanguard Group Inc., Malvern, Pa., to use them.

Mr. Buckalew said he has not yet used any of MSCI's U.S. indexes, "I'm trying to work them in."

To counter some of the charges that S&P's methodology is a drawback, the company late last year acquired Citigroup's global benchmark indexes. The S&P/Citigroup indexes are reconstituted annually based on market cap.

"By our acquisition of Citigroup indexes, we made a clear statement to Russell and MSCI that we're interested in eating your lunch," Mr. Blitzer said, adding that the ongoing trend in the index business is likely to be just that.

"I think there are two or three trends that stand out and the first is that increasingly we are all going after each other's turf," he said.

The other trends are an increasing move to provide global indexes and developing custom indexes, he said.

"We want to have an index for every use," he said.