From the February 2008 issue of Research Magazine • Subscribe!

February 1, 2008

Focus on FTSE

The FTSE Group is a world leader in the creation and management of equity, bond and hedge fund indices. Their indices are used for investment analysis, performance measurement and the creation of index-based funds.

The company is an independently run enterprise owned by the Financial Times and the London Stock Exchange. While FTSE may not have the same cachet as Dow Jones and Standard & Poor's in the United States, it offers many compelling indices that a number of exchange-traded funds (ETFs) have been developed to track.

Research was recently pleased to have Jerry Moskowitz of FTSE Americas join us to discuss the company and its products.

Research: How many indices does FTSE Americas manage? Moskowitz: FTSE Group calculates over 100,000 indices covering more than 48 countries and all major asset classes. Our flagship index, the FTSE Global Equity Index Series (GEIS), covers 98 percent of the world's total investable market capitalization and includes a broad range of traditional and alternative asset class indices such as multinationals, infrastructure, socially responsible investment, real estate and hedge funds.

What are some characteristics of a well-designed index?A well-designed index is transparent, rules-based and liquid to ensure investabilty. FTSE has a set of standards that all of our equity indices must meet. First of all, they must have clear rules that are publicly available. All stocks within the indices must be free-float-adjusted and meet our liquidity screens. Finally, any and all index changes are clearly communicated. The results of index reviews and resulting changes are available on our website and communicated to clients and the press.

There's been a proliferation of new stock indices and that has been followed by a lot of confusion. What's the difference between a market index and an index designed to beat the market?An index, by definition, is designed to represent the market it follows. The FTSE 100, for example, covers the largest 100 UK companies as measured by their market capitalization (stock price times shares outstanding). When the market is up, so is the index -- and when the market is down, the index is down as well.

When you refer to an index designed to "beat" the market, you are describing what we call "investment strategy" indices. These are alternatively weighted indices like the FTSE RAFI series, which weights company size by sales, cash flow, book value and dividends as opposed to market cap. In many instances, particularly during the collapse of market bubbles, these indices outperform traditional market-cap-weighted indices.

Another way that investors sometimes use indices to "beat" the market is to use "alternative investment" indices. These include indices that cover well-performing and/or rapidly growing markets or market segments, such as China A shares, real estate or infrastructure. There is no guarantee that any of these indices will outperform, however. They are calculated to follow a specific segment of the market, and as with any index, past performance does not guarantee future results.

We've witnessed a heated debate about fundamentally weighted indices versus market capitalization-weighted indices. FTSE Americas has a stake in both methodologies. Please explain.As an index provider, FTSE strives to provide our clients with the best and most innovative variety of indexing options. While the fundamental strategy is a great method, it is not the only method of calculation. We are not investment advisors and it would be remiss of us to promote one method over the other. Our job is to offer the choice.

Tell us about the FTSE RAFI series of fundamentally weighted indices. How do they work?The FTSE RAFI series uses four criteria to measure companies' size: sales, cash flow, book value and dividends. The idea is to eliminate market noise and investor emotion from index performance. In a traditional market-cap-weighted index, stock price affects the weight of a company within the index. So it makes sense that in market bubbles such as the recent dot-com bubble when stock prices were driven up by speculation, high hopes and rumors, overvalued companies were overweighted within market-cap-weighted indices and likewise undervalued companies were underweighted. The fundamental method eliminates these inefficiencies.

Let's talk about some specific FTSE stock indices. Vanguard has an ETF that follows the FTSE All World ex-US Index (VEU). How is this index different from the widely followed MSCI EAFE index?The FTSE All-World ex-US Index consists of companies located in developed and emerging markets around the world, excluding the United States. The index includes approximately 2,200 holdings in nearly 50 countries, including a 5 percent weighting for Canada. Canada is not a component of MSCI EAFE, giving investment products that track the FTSE All-World ex-US Index broader exposure to foreign developed equity markets. This is important because Canada is considered one of the world's wealthiest nations and boasts a GDP that ranks amongst the top 20 in the world, in a tier alongside South Korea, Brazil, Mexico and Italy. The strong performance of the Canadian S&P/TSX Composite Index (which includes the largest companies on the Toronto Stock Exchange) over the past few years demonstrates how robust and important Canadian equity markets can be in a global portfolio.

Another ETF is the SPDR FTSE/Macquarie Global Infrastructure 100 (GII). What's the idea behind investing in infrastructure companies?Offering infrastructure indices is another terrific example of FTSE bringing an innovative alternative benchmark to market. In recent years, there has been a huge amount of worldwide growth in infrastructure, and market demand for an index that tracks the industry led us to the decision to offer this series. The FTSE Maquarie series is the most comprehensive infrastructure index series to date, and it is based on 258 stocks currently in the FTSE Global Equity Index Series, comprising companies principally involved in the management, ownership and/or operation of infrastructure and utility assets.

Many new index providers have popped up and promoted the idea that new and improved indexing methods are badly needed. Yet, some indices have questionable investment merit. At what point does the evolution become a devolution?This brings us back to your question about what makes a good index. It is important in the calculation of indices to make sure that you are accurately representing the market and that the index has a clear set of rules that are readily available to the public. Liquidity is a big issue as well -- for an index to be investable, you have to be able to trade the stocks within it. If an index isn't meeting these standards, then that's a pretty good sign that it's going to create problems in some eventuality.

Where are we at in terms of the innovation being done in the indexing world? The first inning? Third? Or the ninth?As markets change and evolve, the indexing business will continue to grow and change with them. Today's investors are more sophisticated than ever before, they are demanding access to global markets, new asset classes and alternative investments. As long as there is investor demand and changing markets, there will be an opportunity to innovate. While the industry has certainly gone though an intense period of change and innovation over the past few years, there is always more to be done and FTSE is proud to lead that evolution.

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Ron DeLegge is the San Diego-based editor of www.etfguide.com.

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