Bogleheads® on Investing Podcast 002 – Dr. David Blitzer, host Rick Ferri (audio only)

00:00:00.000 | Welcome, everyone, to the Bogleheads on Investing podcast, episode number two.

00:00:16.400 | In this episode, we have a special guest, Dr. David Blitzer, Managing Director and Chairman

00:00:23.800 | of the Index Committee at S&P Dow Jones Indices.

00:00:38.360 | My name is Rick Ferry, and I'm the host of Bogleheads on Investing, a podcast made available

00:00:44.760 | by the John C. Bogle Center for Financial Literacy, a 501(c)(3) corporation.

00:00:52.440 | In this episode, we're talking with David Blitzer, Managing Director and Chairman of

00:00:58.480 | the Index Committee at S&P Dow Jones Indices, who has the overall responsibility for index

00:01:04.800 | security selection as well as index analysis and management.

00:01:10.760 | Before Dr. Blitzer became the Chairman of the Index Committee, he was Standard & Poor's

00:01:15.540 | Chief Economist.

00:01:16.840 | Dr. Blitzer can discuss many things with us about the Dow Jones Industrial Average and

00:01:22.540 | the S&P, which he is the head of the committee, but there is one thing he cannot discuss.

00:01:26.840 | He cannot tell us which stocks they are going to be selecting next for those indexes, which

00:01:32.160 | are highly confidential until the day that they're announced.

00:01:35.640 | However, today we are going to be talking a lot about the methodology behind the selection

00:01:42.400 | of various stocks that go in and out of the Dow Jones Industrial Average and the S&P 500,

00:01:48.360 | as well as many other indexes.

00:01:50.680 | In addition, we'll talk about how the world has changed because of indexing.

00:01:55.440 | It's no longer just a benchmark, it's now an investment strategy, and that has changed

00:02:00.440 | the entire indexing industry.

00:02:03.240 | Finally, we'll talk about how active managers are having a very difficult time beating indexes,

00:02:10.080 | not only in the United States, but globally, and how that is expanding the use of indexing

00:02:16.120 | and index products.

00:02:18.120 | Let's get to our podcast.

00:02:21.240 | With no further ado, let me introduce Dr. David Blitzer of S&P Dow Jones Indices.

00:02:27.760 | Good morning, Dr. Blitzer.

00:02:29.680 | Good morning.

00:02:30.880 | You can call me David, and it's a pleasure to be here.

00:02:33.280 | Okay.

00:02:34.280 | Thank you, David.

00:02:35.280 | Well, you have a lot of responsibility.

00:02:38.800 | How many indexes are you following at S&P Dow Jones?

00:02:43.120 | I guess two points of background to start off.

00:02:47.680 | We usually talk about something like a million indices produced on a daily basis, which sounds

00:02:53.520 | like an incredible amount, but one has to think about how indices sort of break down

00:03:00.000 | into other indices.

00:03:02.560 | If you think about the S&P 500, which is obviously a single index, but each company in the index

00:03:08.720 | is categorized into a sector like technology, an industry group, an industry, and a sub-industry,

00:03:17.280 | and for all those categories, we create other indices as well.

00:03:21.480 | Plus, we may have a version that's equally weighted instead of weighted by market value

00:03:26.240 | and so on.

00:03:27.240 | So the single S&P 500 by itself begets probably close to 500 indices, and that's how we get

00:03:36.080 | to this surprisingly high number of a million.

00:03:40.120 | In terms of committees, we actually have about 45 committees organized by geography, by stocks

00:03:48.880 | versus bonds versus commodities, and that kind of thing.

00:03:53.320 | In some cases, we run indices in cooperation with an exchange.

00:03:59.240 | An example would be we run indices in Canada called S&P TSX, TSX is Toronto Stock Exchange.

00:04:05.960 | There's a committee for just those Canadian indices, which has people from the Toronto

00:04:11.760 | Stock Exchange as well as people from S&P Dow Jones sitting on it.

00:04:16.400 | I directly chair probably about 15 of the 45 committees, and I sit on most of the other

00:04:23.520 | ones.

00:04:24.520 | So it sounds like a lot of responsibility, especially since some of the biggest indexes

00:04:30.280 | we know of, such as the S&P 500 and the Dow Jones Industrial Average, are included in

00:04:35.360 | those.

00:04:36.360 | I have a question about that.

00:04:37.760 | It wasn't always S&P Dow Jones Industrial Average.

00:04:41.560 | When did it start to become S&P Dow Jones Industries as opposed to S&P Indices and a

00:04:49.800 | separate company called Dow Jones?

00:04:51.480 | There must have been some sort of a merger or acquisition along the way.

00:04:54.520 | There was a merger, or maybe one called a combination, that was completed in the second

00:05:01.400 | half of 2012.

00:05:03.280 | There was a bit of history behind it.

00:05:07.880 | To go back a ways, Dow Jones was originally owned by Dow Jones & Company, which owns The

00:05:13.360 | Wall Street Journal.

00:05:15.120 | I won't get all the dates right, but around about 2005 or 2006, News Corp., which now

00:05:22.480 | owns The Wall Street Journal, acquired Dow Jones & Company.

00:05:28.380 | Following that, News Corp. looked around, and they ended up selling it to the Chicago

00:05:33.480 | Mercantile Exchange, which people probably know because futures on indices are traded

00:05:39.180 | on the Chicago Mercantile Exchange, or the CME.

00:05:41.880 | We rolled forward a couple of years, and the CME out in Chicago found itself running

00:05:48.800 | a bunch of indexes in New Jersey that had a big interest in indices also, and that is

00:05:55.760 | the futures on the S&P 500 are traded on the Chicago Mercantile Exchange, or what we sometimes

00:06:01.240 | call the Merck.

00:06:03.080 | At the same time, S&P was very interested in what was going to go on because of the

00:06:07.280 | Dow Jones Industrial Average, which we knew to be a widely followed major index.

00:06:12.160 | The result of a series of discussions and arrangements was that two firms got together

00:06:18.120 | and really brought a lot of complementary strengths.

00:06:21.560 | There were certain ideas that people at Dow had done, which we wish we had done.

00:06:27.880 | One of the first really successful indices based on dividends was done by Dow and very

00:06:34.200 | successful, and we've done some, but not quite as successful as that.

00:06:39.800 | They looked at us and we had been much more successful with big institutional investors

00:06:45.480 | and the 500 than they had been with the Dow, and it just made sense to put everything together.

00:06:52.760 | Obviously it took a lot of discussion and so forth, but on November 1, 2012, as New

00:06:57.320 | York City was virtually flooded by a storm called Superstorm Sandy, we started doing

00:07:04.180 | business with one company.

00:07:06.080 | Now, if I recall correctly, prior to S&P and Dow Jones doing a business combination so

00:07:15.240 | that your committee or one of your committees took over the Dow Jones Industrial Average,

00:07:20.720 | it was the editors of the Wall Street Journal who were picking the 30 Dow Jones stocks.

00:07:26.040 | Do they still have involvement in that?

00:07:28.480 | Yes, they do.

00:07:30.280 | I don't know first-hand the history of the Dow Jones Industrial Average before 2012,

00:07:35.720 | obviously, because I come from the S&P half of the result, but there was involvement from

00:07:44.440 | the editors of the journal, and recognizing the huge work history of the Dow, it is the

00:07:51.400 | oldest stock index that's currently in existence and still being used and so on, and the input

00:07:57.640 | that the journal provided for almost 120 years at that point, we felt it was important to

00:08:03.880 | keep some involvement with them, and so we created a committee, or maybe you could say

00:08:09.600 | continued an existing committee, called the Averages Committee, which handles the Dow

00:08:14.640 | Jones Industrial Average, the Dow Transports, and the Dow Utilities, and that committee

00:08:20.520 | has five people on it, three representing S&P Dow Jones indices, and two from the Wall

00:08:27.160 | Street Journal.

00:08:28.160 | Sitting on that committee and chairing it, it's not only very welcome, but very good

00:08:34.440 | to have two people from the journal.

00:08:36.240 | They bring a slightly different perspective than we do in terms of how they see the economy

00:08:41.600 | and the markets and developments in the news.

00:08:44.840 | They're both very sharp, and it's worked out very well, and I think I'm very pleased to

00:08:53.280 | not just continue the role of the Wall Street Journal's editorial group, but really to have

00:09:00.000 | two very good people on the committee.

00:09:03.040 | I recall a conversation we had a couple of months ago when the committee decided to take

00:09:07.520 | out General Electric from the Dow Jones.

00:09:10.760 | It appeared that it was going to be a big shock that GE was coming out of the Dow Jones

00:09:14.640 | Industrial Average, but it turned out that it really wasn't a big shock.

00:09:18.640 | People quickly accepted that.

00:09:20.840 | GE was one of the original members of the Dow, and "original" means 1896.

00:09:29.200 | It had been in the first 15-20 years of the Dow, it was in and out a few times.

00:09:36.080 | But probably from the early to mid-1920s, GE was continuously a member of the Dow Jones

00:09:41.280 | Industrial Average up until this year, and given the history of the company and its history

00:09:49.440 | with the index and so on, this is not something one does lightly.

00:09:53.680 | Obviously, we don't take any company out or put any company in an index like the Dow lightly,

00:09:59.600 | but this one gets even more consideration.

00:10:02.360 | GE has fallen on some difficult times.

00:10:07.320 | Various people have various explanations and so on, and since I'm not an analyst on GE

00:10:12.960 | in particular, I won't leave any of those details aside, but it had fallen on some difficult

00:10:18.640 | times, and I think its weaknesses were widely recognized, even though some people wanted

00:10:26.420 | to carry it in.

00:10:27.420 | But as we looked at it, in an index you only have 30 names, because that's the rules.

00:10:33.720 | We really felt we shouldn't use a name on one stock that wasn't doing that well.

00:10:38.400 | A lot of people didn't think it was going to do that well, and given the way the Dow

00:10:42.280 | was calculated, it wasn't having any impact on the index at all.

00:10:46.320 | So it was not a difficult call once we sat down to talk about it.

00:10:51.440 | And it's interesting you say that it didn't have a big impact on the Dow, because the

00:10:56.000 | Dow Jones is an unusual index.

00:10:58.280 | It is weighted by the price of the stock, which the larger the price, the more influence

00:11:04.480 | or impact a change would have on the index.

00:11:09.120 | And isn't this one of the reasons why companies that have very, very large prices and thousands

00:11:14.720 | of dollars may not work well in the Dow Jones 30?

00:11:19.160 | That's right.

00:11:20.160 | The Dow, as you mentioned, is unusual.

00:11:23.080 | The only other index I know of that's done that way is the Nikkei 225 in Japan, although

00:11:28.720 | I'm sure there are a couple of others that haven't come across.

00:11:34.200 | And when we look at stocks in the Dow, we'd like the ratio between the highest price stock

00:11:39.360 | and the lowest price stock to be not much more than 10 to 1.

00:11:43.720 | So GE, when it came out, was probably about $12 or $13 a share.

00:11:48.920 | The highest price stock in the Dow at that point was around $200 or more.

00:11:54.360 | And GE didn't have much impact that a $200 stock would have had, you know, 8 to 10 times

00:12:01.360 | the impact of GE on the value of the index.

00:12:04.720 | And it just didn't make sense to do that, so we replaced it with a slightly higher price

00:12:11.440 | stock that we felt was a better representation of what was going on in the economy and the

00:12:17.200 | markets.

00:12:18.200 | And I think, you know, after the initial excitement wore off in a day or two, it was generally

00:12:25.040 | applauded, and I think people are more comfortable with the Dow the way it is now than the way

00:12:30.240 | it was when we still had GE in the last days.

00:12:34.160 | Let's go over to the S&P 500.

00:12:36.880 | I've been in the business about 30 years, and I've seen some pretty large changes to

00:12:41.040 | the methodology by which the S&P 500 calculated.

00:12:46.240 | I believe back in the 1990s, there was a couple of changes concerning -- I was going from

00:12:52.120 | a full capitalization to a float capitalization methodology, and then there was a change is

00:13:00.000 | what stocks are actually U.S. stocks and what stocks are non-U.S. stocks.

00:13:06.760 | Could you talk about some of these big, major changes that have occurred in the S&P over

00:13:11.320 | the last, say, 25 years?

00:13:13.680 | Okay.

00:13:14.680 | I think that the background that people should recognize is, you know, clearly the world

00:13:21.040 | changes, the economy changes, the way people use indices change, and so to run an index

00:13:28.480 | today the way it was run, let's say, in 1982 when futures trading started, would be pretty

00:13:36.640 | silly, and it wouldn't work that well, and there have been a lot of changes since then.

00:13:41.400 | Probably the biggest change is the amount of money that tracks the S&P 500, which means

00:13:46.800 | it's a lot more visible, and changing companies makes a bigger difference and so on than it

00:13:55.200 | did 30 or 40 years ago or something like that.

00:13:58.880 | The float change I think was actually in the early 2000s, the idea being that, well, first,

00:14:06.480 | the S&P had always had a rule that for a stock to be in the index or when it was added to

00:14:12.200 | the index, at least half of the outstanding stock should be available to the public.

00:14:16.440 | So if you had a company where the insiders or the founders or whatever owned 80% of the

00:14:22.880 | stock, that was nice, I'm sure they were doing very well, but it wouldn't be eligible for

00:14:27.800 | the S&P 500.

00:14:29.400 | But even with that rule, there was concern that we had some stocks that were just not

00:14:35.400 | very liquid and might be difficult to trade, especially in the lower, the smaller stock

00:14:40.520 | end of the index, and as trading and as exchange-traded funds became bigger and bigger, those became

00:14:48.880 | something of an issue for a lot of people.

00:14:50.880 | So what we did was we went to float, where we go through, once a year, the proxy statements

00:14:57.880 | that companies file with the SEC, and we do our best to figure out what proportion of

00:15:04.320 | the stock is actually in the market and what proportion is locked up in holdings by insiders

00:15:11.960 | or holdings by another company, and holdings by another company would mean if both companies

00:15:18.400 | are in the index, we sort of double counting, things like Berkshire owns big chunks of various

00:15:25.680 | different large companies in the index, or where the stock just wasn't available because

00:15:32.120 | the founding family wasn't going to sell because they didn't want to, and so we made the adjustment

00:15:37.760 | to be what we call float-adjusted.

00:15:40.120 | So if a company had 80% of its stock in the index, we would count that 80% to be in the

00:15:47.320 | market, and we'd count that 80% as being available in the index, and then we'd take the total

00:15:52.760 | shares outstanding and multiply it by .8, and that would be the number of shares we'd

00:15:57.320 | use for index calculation.

00:16:00.200 | It was a fairly big change, although if you took the all 500 stocks, you just took an

00:16:06.920 | average of the percentage of each company's stocks or shares that was available in the

00:16:12.720 | index, that came out about 93% or something, so there were a handful of companies that

00:16:18.800 | were just a fairly big change, but the vast majority, we're talking about a few percentage

00:16:26.120 | points change in their value as measured in the index.

00:16:32.000 | The domicile, or what we call domicile, which is how do you know if this is a U.S. company,

00:16:38.760 | which sounds sort of silly and obvious to most people, but it got more complicated.

00:16:45.160 | In about 2007, 2008, 2009, two things happened.

00:16:52.120 | First, a lot of U.S. companies started changing their incorporation to Switzerland, Ireland,

00:16:59.040 | various places in the Caribbean, Bermuda.

00:17:02.760 | They all wanted to avoid paying U.S. taxes, which is again in the news in the last year

00:17:07.480 | or so, and initially the index committee, as the first two or three of these came along,

00:17:12.800 | said those violate the rules because the index is supposed to be U.S. companies.

00:17:18.160 | It's not supposed to be Swiss companies or Irish companies or whomever, and we started

00:17:25.160 | telling these companies out one by one.

00:17:28.000 | We then very quickly heard from a lot of investors, some individual investors, who said, "I've

00:17:34.560 | owned this company for 40 years and now you're telling me it's not what it used to be," some

00:17:40.160 | big institutional investors who were a little more vocal than the individual investors possibly.

00:17:46.940 | So we went around listening to people and talking to people.

00:17:51.340 | We hold an annual meeting called an advisory panel where we invite in a lot of major institutional

00:17:58.200 | investors and let them tell us what they like and don't like about our indices.

00:18:03.000 | Out of that came the feeling that what a U.S. company should be slightly different than

00:18:09.080 | where do you incorporate.

00:18:11.720 | The two key things that investors tell us about is, number one, how do you report your

00:18:18.380 | financial results?

00:18:19.380 | Do you report them to the SEC as a U.S. company?

00:18:22.400 | Do you file a 10-K and a 10-Q?

00:18:25.560 | That's from an investor's point of view.

00:18:28.080 | If you don't do that, then you're not U.S.

00:18:31.640 | Second of all, where do you see stock trades?

00:18:34.960 | And there it's pretty simple.

00:18:35.960 | New York Stock Exchange, NASDAQ, those are the two major U.S. exchanges that get mentioned.

00:18:42.200 | Our rules now say if you do those two things and if you have at least a large portion of

00:18:48.880 | your assets or your employees or your activities in the United States, you're a U.S. company.

00:18:54.680 | The last rule is there are a few Chinese companies that the only place they trade is New York

00:18:59.440 | and NASDAQ.

00:19:00.880 | They report on a 10-K to the SEC, but all their business activities are in China, but

00:19:10.000 | we don't think they're U.S. companies.

00:19:13.000 | It's interesting what you said about going out to investors, large institutional investors,

00:19:17.760 | and before you make a big change to the index, you actually speak with the others in the

00:19:22.960 | industry and you speak with large investors and the S&P 500, and you get their input into

00:19:30.000 | changes that you're considering before you make them as opposed to doing it in a vacuum.

00:19:35.920 | Do you do that when you're looking at potentially putting a new company in, taking a new company

00:19:43.600 | out?

00:19:44.600 | Do you get input from the industry?

00:19:46.400 | Yeah, I think because here the rules and the regulations have been changing a lot over

00:19:52.160 | the years, and so we should be very careful as to explaining what we do and don't do.

00:19:58.960 | When it comes to considering adding a company or removing a company from the S&P 500, pretty

00:20:06.520 | much the same thing is true for any index.

00:20:10.720 | Those discussions are absolutely confidential, and they're so confidential that the only

00:20:17.440 | people within S&P Dow Jones who are permitted to be involved with them are those of us who

00:20:22.640 | work specifically on the indices, and for those of us, the ones working directly in

00:20:29.200 | the indices, we cannot do anything commercial.

00:20:32.800 | I can't quote a price, I can't negotiate a contract, that's completely off-limits and

00:20:39.000 | so on.

00:20:40.840 | So market-moving things like adding a stock to the S&P 500, those discussions, that research,

00:20:48.840 | that analysis is restricted to a very small group of people, essentially the one sitting

00:20:53.280 | on the index committee that covers the index, and we don't talk to anybody until we publish

00:21:00.120 | an announcement on our website and give it to the news media, which says this company

00:21:05.520 | is being added at such and such a date, or this company is being removed.

00:21:09.400 | So those kinds of discussions, the ones that are really market-moving, we keep them under

00:21:15.720 | wraps.

00:21:16.720 | Other discussions, much more general things, like how would you define what company is

00:21:22.360 | a U.S. company, for those, we will invite comments.

00:21:27.960 | What we do the vast majority of times is we'll publish a letter or paper on our website and

00:21:35.400 | explain what the issues are and ask people to send us their comments, in fact, they can

00:21:41.560 | go on our website and fill out the information right there, and at the same time, if we know

00:21:48.360 | of investors, whether institutional or individual, who would have an opinion or be interested,

00:21:55.440 | we want to make sure we hear from them, and we will send them an e-mail and say we've

00:22:00.080 | just published a consultation on this matter, and we would appreciate a response.

00:22:05.040 | So we do reach out with that, but even with those, if we're doing a consultation on a

00:22:10.880 | particular question, we'll ask for a lot of input from people, but we're not going

00:22:15.960 | to tell anybody what we're going to do until we publish the result for everybody.

00:22:19.600 | So we're very concerned that crucial information, all investors have equal access, same time,

00:22:27.680 | same information, and so on, and if we're toying with something that's going to be market-moving,

00:22:35.120 | we're going to keep it to ourselves until we tell everybody at the same time.

00:22:40.840 | That's the way we run what we feel is a fair and transparent index.

00:22:45.240 | Is it fair to say that if a very large company comes out of the index, then you're trying

00:22:51.320 | to find an equally-sized company or something close to it?

00:22:55.080 | Like you talked about with the Dow Jones Industrial Average price, as far as S&P, given a cap-weighted

00:23:01.520 | index, if a $100 billion cap-weighted company comes out, are you looking for something close

00:23:08.280 | to that to put in?

00:23:11.320 | I'm not sure there are too many $100 billion companies floating around there that are not

00:23:14.840 | in an index, actually, but for the 500, there are a series of rules.

00:23:23.880 | One we mentioned already has to be a U.S. company.

00:23:27.520 | Its market value should be, currently I believe the minimum is about $6.8 billion at a minimum

00:23:34.440 | at the time it goes in, it should be profitable, meaning on gap earnings, it should have made

00:23:40.680 | money over the last year, and that's an unusual rule for an index.

00:23:45.240 | It should be liquid.

00:23:46.240 | If it's not liquid, somebody will have a hard time trading the stock, and so on.

00:23:51.480 | Those rules are public, and the company we choose should comply and does comply with

00:23:58.080 | those rules, and so on.

00:24:00.600 | All that's published in a thing called the U.S. Indices Methodology, it's up on our website.

00:24:06.920 | Some people may tell you it's a great cure for insomnia, but other people say it's actually

00:24:10.920 | worthwhile reading.

00:24:11.920 | All right.

00:24:12.920 | Thank you.

00:24:13.920 | Let's get into some big changes that have taken place in industry classifications that

00:24:19.560 | have occurred over the last couple of years, and you could probably start out with an overview

00:24:24.000 | of the Global Industry Classification System, GICS, or standards, is it, and what that is,

00:24:34.760 | and then how does that all work into the S&P and what you're doing?

00:24:40.360 | It's a global change.

00:24:41.360 | It's very large changes that have taken place.

00:24:43.400 | Can we talk about that for a minute?

00:24:45.640 | GICS is the Global Industry Classification Standard.

00:24:49.720 | It's a system for classifying companies into a sector, which, for example, would be technology

00:24:56.720 | or healthcare, an industry group, and then within that, within an industry group, there'll

00:25:02.800 | be one or more industries, and within each industry, there'll be one or more sub-industries,

00:25:07.520 | so that at the very bottom, there are around 160 sub-industries, which is a pretty detailed

00:25:14.520 | statement as to what a company does.

00:25:18.520 | And it's done principally by looking at where the company gets its revenues.

00:25:22.600 | We also will look at earnings, and at times, we'll look at the way the market perceives

00:25:27.640 | a company and that the market sometimes sees a company doing one thing even though it does

00:25:33.160 | something else that's a little bigger.

00:25:35.720 | GICS is an effort that's maintained or run jointly by S&P Dow Jones Indices and MSCI.

00:25:44.920 | We've been running it together since it was created in about 1999, and on a global basis,

00:25:51.320 | I don't remember the exact numbers, but essentially, any publicly held company anywhere in the

00:25:57.480 | world that an investor is likely to even look at has a GICS classification, sector, industry

00:26:03.360 | group, industry, sub-industry.

00:26:04.360 | Somebody sort of wondered, "Why do you do this?"

00:26:08.080 | Well, the way investors think about markets and what moves markets is they like to have

00:26:13.600 | an idea which ones are going up and which ones are going down, because it's very rare

00:26:18.080 | that everything moves together.

00:26:20.320 | So somebody will say, "The S&P 500 was up 3% last week.

00:26:26.400 | It was led by the technology stocks and healthcare, but consumer discretionary lagged," or something

00:26:32.280 | of that sort.

00:26:33.280 | Those are all names of the major sectors, and people will then tell you what portion

00:26:39.380 | of the 3% was contributed by each sector, some going down sort of reduced the 3%, other

00:26:46.600 | ones pushed it up.

00:26:47.960 | They'll look over a period of time, what's been growing fast, all that kind of thing.

00:26:52.940 | So this year, people have talked about technology stocks leading the way and so on, and the

00:27:00.640 | way they decide whether that's true or not is they'll look at the S&P 500 and they'll

00:27:06.680 | look at how the technology sector within it has done.

00:27:09.880 | In fact, we calculate the S&P 500.

00:27:13.520 | We calculate the technology sector as its own index, and if you break it up into a couple

00:27:19.520 | of industry groups and industries, we calculate indices for all those as well.

00:27:25.080 | So you can take that data and you can see exactly what went up and what went down in

00:27:31.580 | the market by how much, what was pushing the market one way or the other.

00:27:37.160 | You can look at did things change over time, did certain areas react a lot positively or

00:27:44.080 | negatively to changes in government policy, just about anything.

00:27:48.240 | It's really the way to take the stock market and sort of peel back all the layers and understand

00:27:54.360 | what's going on.

00:27:55.360 | So some of the major changes that have occurred in the last couple of years, real estate investment

00:28:01.500 | trusts, or real estate was part of the financial services sector.

00:28:06.860 | You broke that out now and made it its own industry group, which would include real estate

00:28:13.460 | investment trusts or equity.

00:28:16.060 | So you saw that as a significant enough part of the market now to give it its own industry

00:28:21.340 | classification.

00:28:22.340 | That's right.

00:28:25.440 | When GIC started back in '99, other than a handful of real estate investment trusts,

00:28:33.800 | there wasn't much real estate in the stock market to begin with, and we just tucked it

00:28:37.700 | under financial and figured, "Well, all that matters is what the mortgage rates look like,

00:28:42.620 | so let's stick it there."

00:28:45.260 | Coming out of the financial crisis in 2008, 2009, first of all, everybody knew what real

00:28:52.500 | estate was because it had a role in the financial crisis, but second of all, as interest rates

00:28:59.380 | came down and investors started looking for income, real estate and particularly REITs

00:29:05.500 | became an intriguing thing.

00:29:07.740 | The way REITs are structured, they tend to pay very high dividends relative to their

00:29:14.140 | size.

00:29:15.140 | It was getting more understood and indeed that sector was growing.

00:29:19.940 | So we looked at that and we said, "Real estate is increasingly important and maybe it should

00:29:27.020 | really be its own sector," and instead of 10 sectors, we ended up having 11 sectors.

00:29:33.300 | In the process of doing that, we did do a lot of surveys and talked to a lot of people,

00:29:39.300 | institutional investors, individual investors, some brokerage firms, some brokerage firms

00:29:44.820 | that really focused and specialized in real estate and REITs in particular.

00:29:50.500 | Out of that, we, and in this case, it's both S&P Dow Jones and MSCI working together, felt

00:29:57.000 | that real estate deserved to get a little more prominence and be sort of pulled out

00:30:01.300 | from being buried in finance.

00:30:03.860 | The other thing is that maybe back in 1999, real estate and financials sort of behaved

00:30:08.940 | the same way.

00:30:09.940 | By the time you roll forward to the last few years, they weren't behaving the same way

00:30:14.540 | at all and putting them in the same sector, when one would go up and one would go down,

00:30:22.180 | wasn't really helping anybody who was trying to understand what was happening.

00:30:25.180 | If anything, it was just muddying the waters, so we split it out.

00:30:28.980 | A big change occurred here last month with telecoms and technology turning into now technology

00:30:37.960 | and communications, and it was very big because now companies like Facebook, Walt Disney,

00:30:45.620 | Alphabet, which is Google, I mean, some very big companies that we, the investors, have

00:30:50.620 | always said, "Well, if I want to get exposure to those companies, all I have to do is buy

00:30:54.460 | a technology index fund."

00:30:56.900 | That has now changed.

00:30:57.900 | If I wanted to buy a industry-specific index fund to get exposure to Facebook or to Google,

00:31:05.860 | I now need to buy something called communications services because it's not being looked at

00:31:10.980 | as a technology company anymore.

00:31:13.540 | That's true, and I guess there, the background is maybe more detailed but I think more interesting

00:31:21.220 | than in the real estate story.

00:31:23.820 | The first thing to say is, for the S&P 500, telecom had gotten down to three companies.

00:31:30.900 | Number three wasn't very big either, so something really ought to change, but in fact, we had

00:31:37.260 | been discussing this and looking at this for three or four years going, and as we looked

00:31:43.780 | at it, we realized that the whole span of what is technology, what is communications,

00:31:50.180 | what's telecommunications was going to go in a whole lot of rapid change, give you a

00:31:55.500 | sense.

00:31:56.500 | Telecoms are about ten and a half years old.

00:31:58.700 | Eleven years ago, nobody had an iPhone.

00:32:01.340 | It didn't exist.

00:32:02.340 | Nobody had a smartphone because the iPhone was essentially the first smartphone.

00:32:07.740 | Well back even a few more years, certainly at the beginning of the century but probably

00:32:12.580 | well in the first decade, if your company had a website, that was pretty high technology.

00:32:18.460 | Nowadays, nobody will admit they haven't had a website forever.

00:32:24.700 | How did people communicate ten, fifteen years ago?

00:32:28.900 | It was a telephone, like the one we're talking about right now has wires.

00:32:33.540 | Email was sort of a rarefied thing.

00:32:35.180 | You had to be in a university in 1995 to have email.

00:32:39.660 | It just didn't exist.

00:32:42.260 | Nobody text anybody because nobody quite knew what that was, and probably a few people still

00:32:48.460 | remember telegrams.

00:32:50.820 | The world has really changed a whole lot.

00:32:52.740 | The way people...

00:32:53.740 | I remember telegrams.

00:32:54.740 | So do I.

00:32:55.740 | Maybe I once sent one or something, but anyhow, we don't want to date ourselves too much.

00:33:02.540 | As we started looking at this and we said, "All right, what are all these things doing?"

00:33:08.500 | and they're doing communications.

00:33:10.740 | Some of it's sort of back and forth two-way communications, what we're doing right now.

00:33:16.460 | Some of it's broadcast communications, and part of communications is movies, television,

00:33:24.940 | streaming, anything and everything, entertainment or virtually all entertainment.

00:33:33.460 | All of that is part of communications.

00:33:36.580 | On top of that, companies are jumping from one part to another part to another part.

00:33:41.300 | AT&T and Verizon, one of them owns a chunk of Time Warner.

00:33:46.060 | The other one owns Yahoo and so on.

00:33:49.180 | So this has all changed.

00:33:51.060 | For most people, communicating today means reading about their cousins on Facebook or

00:33:59.180 | sending texts on WhatsApp or on and on and on.

00:34:03.380 | So it's all changed, but it's all blending into each other in terms of the way the companies

00:34:08.580 | operate and on that basis, not only did we realize telecommunications, the old definition

00:34:15.500 | didn't make any sense, but we really had to understand what the new thing should look

00:34:19.940 | like.

00:34:20.940 | Facebook is very much the way people communicate and it's not to say anything improper or unkind

00:34:28.460 | about their technology, but their real business is advertising and helping people communicate

00:34:35.340 | and Google is very much the same way.

00:34:37.620 | Their real business is advertising and search.

00:34:41.220 | That's the reason for the change.

00:34:46.100 | Yes, I admit that a few companies used to love the technology, you have to look a little

00:34:50.380 | bit farther to find them, but I think if you asked them or looked at their financial statement,

00:34:57.460 | you'd discover they've been in communications for the last few years, if not longer.

00:35:02.820 | Getting back to indexes in general, back when I entered the business, indexes like the S&P

00:35:08.300 | 500 were not used as a way of investing or as a portfolio.

00:35:13.940 | There was one index fund from Vanguard that was out there, which I know you probably have

00:35:22.140 | an interesting story about and I'd like you to share with us if you could.

00:35:25.860 | This has become a big, big business, indexing for the purpose of investing as opposed to

00:35:31.220 | indexing for the purpose of benchmarking or indexing for the purpose of economic measurement.

00:35:38.080 | With the advent of indexing for the purpose of investing, you have to go into a product.

00:35:44.100 | That has significantly changed not only your business, but also the whole indexing business

00:35:51.260 | for all the different index providers and could you talk about the business a little

00:35:54.860 | bit and how things have changed because indexing is now a product for investing in as opposed

00:36:01.900 | to just a benchmark or economic measurement?

00:36:05.660 | Indices actually probably started as advertisements, I mean the best I can tell from reading the

00:36:14.860 | history.

00:36:15.860 | Dow Jones started the industrials because they wanted to get people to buy their newspaper

00:36:21.020 | and it was a feature of the newspaper to have a number that would tell you what happened

00:36:26.100 | in the stock market yesterday.

00:36:28.140 | The S&P 500 started in 1926 with something called the S&P 90.

00:36:32.900 | Standard & Poor's in those days, there were two companies called Standard Statistics and

00:36:39.180 | they were financial publishers.

00:36:40.740 | They published newsletters about how to invest and that's why they started an index as well.

00:36:46.320 | The first individual investor product based on indices was Vanguard and you've mentioned

00:36:53.140 | that you've interviewed Jack Bowles and he can tell you much better than I can first

00:36:58.120 | hand.

00:36:59.120 | I can probably tell you that they didn't have much money at the end of the first year and

00:37:03.360 | everybody told them it was un-American because they were just going to be average and so

00:37:08.940 | on.

00:37:09.940 | We've got hordes of data that proves that the indices in most quarters and most years

00:37:15.240 | outperformed two-thirds or three-fifths of all the active managers out there.

00:37:20.420 | So if being average is beating three out of five people, I'll be satisfied being average.

00:37:27.040 | But in terms of the business, I usually say S&P 500 was present at the creation.

00:37:34.440 | It was the first index in a retail mutual fund with Vanguard.

00:37:40.560 | It was not the first index to have stock index futures traded on it.

00:37:45.880 | It was the first one that was successful and lasted a running length of time with the futures

00:37:51.160 | at the Chicago Mercantile Exchange.

00:37:53.860 | It was the first index in the United States with an exchange traded fund with the big

00:37:59.640 | spider in about 1993 and it's very much still here and by most measurements, it's the biggest

00:38:08.120 | index period.

00:38:09.120 | So it really has been present at the creation.

00:38:13.520 | In the process, it did turn indexing into a business.

00:38:17.480 | I joined S&P by dumb luck about six weeks after futures trading and the 500 started,

00:38:24.420 | which also was the first year that instead of being a cost center, everybody thought

00:38:29.160 | it might actually be a profit center and indeed, it's become that over time.

00:38:35.360 | And the growth has been very strong and very nice and I think it still has a great future

00:38:40.860 | ahead of it.

00:38:41.860 | I don't know.

00:38:42.860 | We go through sort of different steps and so on.

00:38:45.820 | Clearly, at the same time, the number of indices have increased, the variety of indices, which

00:38:51.880 | really means the variety of tools for investors has grown dramatically.

00:38:57.260 | I think I mentioned earlier, indices designed to provide dividend income, which is very

00:39:03.400 | popular with investors, indices to target segments of the market.

00:39:08.640 | We talked about technology stocks and so on, indices that focus on growth stocks or value

00:39:14.700 | stocks or it goes on and on.

00:39:19.100 | So increasingly, any investment strategy that somebody can think up and write down as a

00:39:25.820 | set of rules or a set of steps, somebody else can build an index for and provide it to any

00:39:32.080 | investor who's interested.

00:39:33.080 | That makes it a little complicated because now we have to try to differentiate between

00:39:38.460 | traditional indexes or indexes as benchmarks and indexes as strategies, investment strategies

00:39:45.000 | where any set of rules is all you need to create what's called an index.

00:39:49.700 | And included in that rules is how you weight securities, which means it doesn't have to

00:39:53.460 | be cap-weighted.

00:39:54.460 | It can be weighted any number of different ways, as long as it follows some sort of a

00:39:57.980 | strategy.

00:39:58.980 | So it gets a little bit confusing for investors and we're trying to come up with a differentiation

00:40:02.920 | between -- Jack Bogle likes to call them traditional indexes.

00:40:07.060 | I like to call them benchmark indexes versus strategy indexes and there's a lot of talk

00:40:13.680 | about how to differentiate the two.

00:40:15.420 | Do you have a differentiating term that you use for that?

00:40:20.980 | We probably don't have a term that can widely accept it or something like that to break

00:40:29.980 | one group off from another or something and inside it gets to be too much jargon.

00:40:38.300 | People call that FMC, that means float market cap, which is what you call benchmark index.

00:40:44.340 | But if we wrote that in all the publications, everybody would scratch their heads, so we

00:40:49.300 | don't.

00:40:50.300 | I would agree there's a huge number of different indices out there and there are different

00:40:56.860 | building blocks and different ways.

00:40:59.620 | The two things to remember sort of as the basis is you've got to do two things in building

00:41:04.900 | a stock index.

00:41:05.900 | You have to have a way to select the stocks and you have to have a way to weight the stocks.

00:41:11.940 | If you sort of stick with looking for those two things, an investor should be able to

00:41:17.860 | get a sense of what's going on.

00:41:20.620 | The selection talks about a certain industry or say a stock that has continuously paid

00:41:26.820 | dividends for the last 25 years, that tells you something about what kind of stocks people

00:41:32.500 | are looking for.

00:41:34.340 | And then if they look at the weighting rule, they can also have some idea of what's going

00:41:41.100 | on.

00:41:42.100 | It's a little more subtle maybe, but if you start by saying the market is market cap weighted,

00:41:49.660 | that's the way the market is.

00:41:51.140 | Both stocks out there together, Apple, Google, Facebook, they're big ones, they carry more

00:41:58.620 | weight in the market than some stock that's by size order number 400 down the list or

00:42:04.180 | number 2,000 down the list or something like that.

00:42:07.100 | As soon as I change that, I get different results from the market weighting.

00:42:12.980 | If I make it equal weighting, which is sort of easy to see, the little stocks can get

00:42:19.820 | more weight and the big stocks can get less weight and that will change the results.

00:42:24.660 | If you want to see the impact, we run the S&P 500 both ways.

00:42:29.260 | If I weight them by the dividends they pay, I'm going to get a lot more weight, a lot

00:42:36.180 | more bang from the big dividend stocks and so on.

00:42:40.640 | It gets a lot more complicated as they go down the list, but I think you stick to weighting

00:42:45.780 | and selection and you'll have some idea what's going on in the market and I should add, nobody

00:42:52.940 | knows everything that's going on in the market, so don't go down that trail, you'll never

00:42:56.860 | get to the end.

00:42:57.860 | I know, but given how long I've been doing this and you've been doing this, Rick, I don't

00:43:07.340 | know about you, but I learned nobody knows everything in the market and I like indices

00:43:13.580 | because I'm not a great friend of picking the one stock that will go up this year.

00:43:17.380 | Getting back to the way in which indexes are created with the selection on one side and

00:43:23.100 | the weighting on the other, I don't know if you recall about 10 or 12 years ago, I created

00:43:27.100 | this thing called an index strategy box, which showed the three different basic different

00:43:34.260 | buckets for selecting securities, which are basically covering the market and then screening

00:43:40.220 | the market and then a quantitative method where you pick just a few stocks as a selection

00:43:44.980 | methodology and then on the bottom I had capitalization weighted, fundamental weighted and then fixed

00:43:51.100 | weighted and all the different indexes that were being created sort of fell into one of

00:43:55.500 | these boxes very nicely.

00:43:57.360 | It never took off, but it's the same exact, I'm glad to hear the same thing that you're

00:44:02.420 | saying now as it really hasn't changed very much.

00:44:05.540 | Okay, I remember it in general, I won't say I remember every box in detail.

00:44:13.620 | Got it.

00:44:14.620 | So indexing though in the U.S. has really, seems to be the leader.

00:44:19.140 | We here in the United States have, investors are now embracing indexing and I personally

00:44:24.500 | believe a lot of that has to do with exchange traded funds and the ability of ETFs to reach

00:44:30.060 | a much broader, wider audience in the brokerage industry and in other places.

00:44:35.540 | But indexing and core type indexing portfolios, which seem to be getting the most money, have

00:44:43.380 | really grown in the United States.

00:44:45.740 | But overseas, they seem to be in some places 20 years behind us, but they're getting there.

00:44:52.180 | Do you see that growth just continuing?

00:44:55.340 | I do think the growth will continue, but I think there are some countries which you might

00:45:02.580 | say have an equity mentality or an equity mindset and other ones that have much less

00:45:08.180 | of an equity mindset.

00:45:10.060 | Certainly, we do business in Canada, we do business in Australia, in both cases with

00:45:16.060 | the major stock exchange in each country, they are as focused on equities as the United

00:45:23.420 | States is, their attention, their sophistication, their analysis is comparable to the U.S. and

00:45:30.600 | so on.

00:45:31.600 | The U.K. also has a big equity mentality and so on.

00:45:36.020 | One of our competitors owns the Kingpin Index in Great Britain, we don't, but we definitely

00:45:42.580 | are active there.

00:45:44.340 | But there are other countries, maybe Germany is one that stands out, that traditionally

00:45:49.240 | investors invested through banks, they held a lot more fixed income or a lot more structured

00:45:56.220 | products of various kinds than they held equities and invested directly in stocks, the way Americans

00:46:04.060 | traditionally do.

00:46:05.060 | And as a result, the whole pickup in ETFs and exchange-traded funds is probably a little

00:46:10.940 | bit slower.

00:46:11.940 | Hong Kong has a very active market, China has two major stock markets, the volatility

00:46:20.320 | occasionally worries everybody, no matter where they are.

00:46:23.720 | But there's certainly plenty of equity expansion and ETF growth in a lot of places around the

00:46:30.200 | world.

00:46:31.200 | And it seems to be universally around the world as well, when you're measuring the performance

00:46:36.400 | of the S&P Dow Jones indexes to active management, that's fairly universal around the world that

00:46:44.480 | you get this three out of five managers underperform.

00:46:48.160 | Your SPIVA has really grown, the SPIVA is looking at the performance between active

00:46:54.720 | and your indexes, and you've been doing that now, I think, for 20 years.

00:46:58.680 | You alluded to it a little earlier.

00:47:00.360 | But that's also expanded now, you're doing more and more countries, and you're looking

00:47:04.240 | at this phenomenon occurring across more countries, and do you think that might help to increase

00:47:10.520 | indexing?

00:47:11.520 | Yeah, I think it has.

00:47:13.840 | We introduced SPIVA, which was an acronym for S&P Index Versus Active, it was really

00:47:19.720 | to try and establish a benchmark to compare active managers to our indices, and so on.

00:47:26.880 | We did it in a way that we felt was fair, and so on, and it's been very well received.

00:47:33.120 | I think the surprising part was, we really thought this was strictly for individual investors

00:47:39.040 | who didn't have access to reams of fancy institutional research.

00:47:44.000 | A few years in, we suddenly discovered that a lot of pension funds from municipalities,

00:47:49.840 | you know, the police department here and the fire department there, their trustees were

00:47:55.520 | calling up and saying, "Will you send me the latest SPIVA report?"

00:47:59.000 | They were sitting down in their quarterly meetings and looking at managers they had

00:48:03.120 | hired and saying, "Why can't you do this well?"

00:48:05.880 | And so on.

00:48:06.880 | So what we thought was a low-key thing for the average guy suddenly turned out to have

00:48:11.800 | a lot more impact than we expected.

00:48:14.440 | But I think it's good, reliable data.

00:48:17.800 | Indices don't win every time, but they do win more often than not, and I guess it's

00:48:24.200 | playing the average user to come out ahead.

00:48:26.800 | It's a good business to be in.

00:48:29.200 | We like it.

00:48:30.200 | With that, I want to thank you so much for your time today, David, and we really appreciate

00:48:35.240 | it.

00:48:36.240 | It's the Bogleheads on Investing podcast, and today, my special guest, Dr. David Blitzer

00:48:41.240 | of S&P Dow Jones Indices.

00:48:43.320 | Thank you, David, for being with us today.

00:48:45.920 | Thank you.

00:48:47.340 | This concludes the second episode of Bogleheads on Investing.

00:48:51.560 | I'm your host, Rick Ferry.

00:48:54.080 | Join us each month to hear a new special guest.

00:48:57.320 | In the meantime, visit bogleheads.org and the Bogleheads Wiki.

00:49:02.400 | Participate in the forum and help others find the forum.

00:49:06.840 | Thanks for listening.

00:49:18.480 | (upbeat music)

00:49:21.060 | you

Bogleheads® on Investing Podcast 002 – Dr. David Blitzer, host Rick Ferri (audio only)

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