SEC’s Definition of an Index Is Outdated

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SEC’s Definition of an Index Is Outdated

Postby Rick Ferri » Tue Jun 18, 2013 2:55 pm

The SEC defines an index fund as “a type of mutual fund or unit investment trust (UIT) whose investment objective typically is to achieve approximately the same return as a particular market index, such as the S&P 500 Composite Stock Price Index, the Russell 2000 Index or the Wilshire 5000 Total Market Index. An index fund will attempt to achieve its investment objective primarily by investing in the securities (stocks or bonds) of companies that are included in a selected index.”

Unfortunately, the products that are being launched today as index funds do not fit the SEC’s definition of a broad based market value. Today, it appears to mean any list of securities that are configured and managed in any way. This makes indexing confusing. To make things worse, mutual fund and ETFs that track these lists are being called index funds. I believe the Securities and Exchange Commission (SEC) needs to redefine what an “index” and “index fund” are because they’re not what they used to be.

See...

SEC’s Definition of an Index Is Outdated

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Re: SEC’s Definition of an Index Is Outdated

Postby LadyGeek » Tue Jun 18, 2013 5:19 pm

This topic is a general complaint about the SEC (discussion about its shortcomings), is not actionable, and is locked. See: Forum Policy

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Re: SEC’s Definition of an Index Is Outdated

Postby LadyGeek » Tue Jun 18, 2013 5:52 pm

After receiving a PM, I agree that this thread can be made actionable. Phrasing the comments as a complaint about the SEC is off-topic.

Let's interpret the comments to mean "given that the rules are so loose, how do you decide which index funds can legitimately be called index funds?"

The actionable topic would be: Of all the ETFs (and funds, probably) that claim to be tracking some arcane index, how do you figure out whether it's a real index and how do you decide which to invest in?

Please refrain from complaining about the SEC. This thread is unlocked.
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Re: SEC’s Definition of an Index Is Outdated

Postby Frengo » Tue Jun 18, 2013 6:20 pm

All indexes are "real", even the one tracking all stocks with an "X" in their ticker, or a CFO born in 1965.
It is up to the investor to choose which index he wants to invest in.

Who are we to say this is an index and this other is not ?
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Re: SEC’s Definition of an Index Is Outdated

Postby nisiprius » Tue Jun 18, 2013 6:25 pm

I wonder how anyone can be sure that some of them are real.
The Dynamic Intellidex OTC Index (DYO) is a ... selected quarterly ... based on a proprietary quantitative method. blah blah model... sophisticated... 150 factors... no 48... no seven to fifteen...
Does anybody audit these index providers to make sure they're really doing what they say they're doing? What's to stop them from asking Joe what stocks like likes and saying they were selected by a quantitative model?
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Re: SEC’s Definition of an Index Is Outdated

Postby Frengo » Tue Jun 18, 2013 6:29 pm

Maybe the litmus test should be if the indexing methodology is public...
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Re: SEC’s Definition of an Index Is Outdated

Postby Peter Foley » Tue Jun 18, 2013 6:49 pm

I would agree with the basic premise of Rick statement. A conservative approach to using the term would be to limit it to all or part of the Morningstar style box that is often referred to. So, for domestic: Large cap, Mid Cap, Small Cap (or all cap), Growth, Value or blend.
You could look at international in much the same way, or simply developed market, emerging market, or both.

This leaves out using the term to cover markets segments by business type (e.g. health care or utilities) or region of the world. Is this too narrow?

I personally only use the index types I listed, but I don't slice and dice. This doesn't prevent me from buying a utilities fund, I just wouldn't call it an index fund.
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Re: SEC’s Definition of an Index Is Outdated

Postby Frengo » Tue Jun 18, 2013 6:53 pm

Without thinking too much: Calvert Social Index anybody ?
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Re: SEC’s Definition of an Index Is Outdated

Postby nisiprius » Tue Jun 18, 2013 6:56 pm

Frengo wrote:Without thinking too much: Calvert Social Index anybody ?
Indeed. I personally invested in the Domini Social Index Fund (back when it was an "index" fund, it is now actively managed) and I always wondered about the Domini 400 Social Index, which as far as I know had no use except to be tracked by the Domini Social Index Fund.

By the way: I see absolutely no harm and a certain amount of good if Rick were to personally compile and post on his website, a list of what he considers to be legitimate indexes.
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Re: SEC’s Definition of an Index Is Outdated

Postby Call_Me_Op » Tue Jun 18, 2013 7:03 pm

Isn't this really just a matter of definition? Do you want to stick with the SEC's definition or let the fund industry modify that definition? Doesn't seem like a major issue to me either way - it's just a label.
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Re: SEC’s Definition of an Index Is Outdated

Postby G-Money » Tue Jun 18, 2013 7:08 pm

Peter Foley wrote:I would agree with the basic premise of Rick statement. A conservative approach to using the term would be to limit it to all or part of the Morningstar style box that is often referred to. So, for domestic: Large cap, Mid Cap, Small Cap (or all cap), Growth, Value or blend.
You could look at international in much the same way, or simply developed market, emerging market, or both.

This leaves out using the term to cover markets segments by business type (e.g. health care or utilities) or region of the world. Is this too narrow?

I personally only use the index types I listed, but I don't slice and dice. This doesn't prevent me from buying a utilities fund, I just wouldn't call it an index fund.

Investors in the REIT "index" would probably disagree. I know there are several different RE and REIT indexes (indices?) out there, and I would be surprised if Rick took issue the indexes tracked by Vanguard and iShares in this sector.

Rick's article was reminiscent of a previous article he wrote about "spindexes." Can't seem to track down the old spindex article.
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Re: SEC’s Definition of an Index Is Outdated

Postby LadyGeek » Tue Jun 18, 2013 7:39 pm

G-Money wrote:Rick's article was reminiscent of a previous article he wrote about "spindexes." Can't seem to track down the old spindex article.

Forbes dropped it from the archives (page not found). Maybe Rick can repost it.

Rick has already taken a stab at recategorizing indexes. In fact, we have it in the wiki. Take a look at Index strategy boxes, which is based on his blog Navigating the Maze of Index Strategies.
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Re: SEC’s Definition of an Index Is Outdated

Postby Rick Ferri » Tue Jun 18, 2013 9:01 pm

Here is a 2006 interview where I introduced the idea of SPINdexes.

The proliferation of indexes

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Re: SEC’s Definition of an Index Is Outdated

Postby Frengo » Tue Jun 18, 2013 9:20 pm

I don't really understand the point of all this.
Do you guys think that simply the label "index" makes a product more appealing to a (rather clueless) investor ?

Isn't part of due diligence to get at least a little familiar with the index one is about to invest into ?

I would understand if I purchased a "European Index" product and the manager played the old switcharoo and filled the portfolio with Thai stocks. But I don't think this is what is being discussed here, is it ?

What would be the point of stripping a fund of its index label, when the index is too esoteric ?
If the intent is to protect the innocent, make sure the fund prospectus lists all the risks in a clear format.
But maybe I'm missing the point...
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Re: SEC’s Definition of an Index Is Outdated

Postby Rick Ferri » Tue Jun 18, 2013 10:19 pm

Frengo wrote:I don't really understand the point of all this.
Do you guys think that simply the label "index" makes a product more appealing to a (rather clueless) investor ?


It absolutely does, and an investor doesn't have to be "clueless" to fall for it. Just look at the number of people who think "fundamental indexing" is actually an index. It's not a market benchmark, not used in economics, and not used for asset allocation. Fundamental indexes have zero purpose except to be licenced to product providers and packaged into higher cost mutual funds and ETFs. It is active management dressed up as an index strictly for marketing purposes.

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Re: SEC’s Definition of an Index Is Outdated

Postby Frengo » Tue Jun 18, 2013 10:30 pm

Rick Ferri wrote:
Frengo wrote:I don't really understand the point of all this.
Do you guys think that simply the label "index" makes a product more appealing to a (rather clueless) investor ?


It absolutely does, and an investor doesn't have to be "clueless" to fall for it. Just look at the number of people who think "fundamental indexing" is actually an index. It's not a market benchmark, not used in economics, and not used for asset allocation. Fundamental indexes have zero purpose except to be licenced to product providers and packaged into a higher cost fund. It is active management dressed up as an index strictly for marketing purposes.

Rick Ferri

I fully agree.
Is there somebody who buys "fundamental index" because there is "index" in the name and doesn't have a clue of what it is, nor does he care ?
I think it is more likely that this unfortunate soul read a cereal box description of what the index does and found it makes total sense (to him).

Along the same line of reasoning, shouldn't we ask SEC to stop classifying as funds those funds with exorbitant fees ?
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Re: SEC’s Definition of an Index Is Outdated

Postby LadyGeek » Tue Jun 18, 2013 10:33 pm

Rick Ferri wrote:
Frengo wrote:I don't really understand the point of all this.
Do you guys think that simply the label "index" makes a product more appealing to a (rather clueless) investor ?

It absolutely does, and an investor doesn't have to be "clueless" to fall for it. Just look at the number of people who think "fundamental indexing" is actually an index. It's not a market benchmark, not used in economics, and not used for asset allocation. Fundamental indexes have zero purpose except to be licenced to product providers and packaged into higher cost mutual funds and ETFs. It is active management dressed up as an index strictly for marketing purposes.

Rick Ferri

The wiki has further info: Fundamental Indices

The construction of a RAFI index begins with the selection of a company universe (for example the FTSE All US All Cap Index, or the FTSE Developed ex US Index) and a screening process that ranks the companies according to four fundamental valuation factors: sales, cash flow, book value, and dividends...

Cap-weighted vs. fundamental indexes are debated constantly. See the Forum discussions in the "External links" section for additional insight.
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Re: SEC’s Definition of an Index Is Outdated

Postby LadyGeek » Sat Jun 29, 2013 12:12 pm

LadyGeek wrote:
G-Money wrote:Rick's article was reminiscent of a previous article he wrote about "spindexes." Can't seem to track down the old spindex article.

Forbes dropped it from the archives (page not found). Maybe Rick can repost it.

Rick has already taken a stab at recategorizing indexes. In fact, we have it in the wiki. Take a look at Index strategy boxes, which is based on his blog Navigating the Maze of Index Strategies.

I'm bumping this thread because I found Rick's article using a Google search (which led back to Forbes): Don't Be Fooled By SPINdex Funds
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Re: SEC’s Definition of an Index Is Outdated

Postby tetractys » Sat Jun 29, 2013 12:38 pm

I think an index for investors should be both transparent and clear. Other than that, an index should be able to measure any perimeter(s) the index makers, being part of a free market themselves, wish to create. Innovation is a good thing largely. Whether the index is proprietary or publicly available doesn't enter into the equation IMO.

The following definition of an index fund which Rick pulled from the SEC for his article is very broad and open to interpretation:
A market index tracks the performance of a specific ‘basket’ of stocks considered to represent a particular market or sector of the U.S. stock market or the economy. There are indices for almost every conceivable sector of the economy and stock market.

There is nothing in the SEC's definition, as far as I can see, why any myriad of indexes cannot be invented and marketed by entrepreneurs. And further I think, it would be extraordinarily backwards and unfair to society to limit that innovation and creativity to only indexes favorable to certain individuals. -- Tet
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Re: SEC’s Definition of an Index Is Outdated

Postby Rick Ferri » Sat Jun 29, 2013 1:54 pm

tetractys wrote:I think an index for investors should be both transparent and clear. Other than that, an index should be able to measure any perimeter(s) the index makers, being part of a free market themselves, wish to create. Innovation is a good thing largely. Whether the index is proprietary or publicly available doesn't enter into the equation IMO.


I never had an problem with innovation and agree it is a good thing. The question is whether these products should be called "indexes" and the funds that follow them called "index funds."

It is proper for a dairy farm to label "reduced fat" milk as "fat-free" milk because the term "fat-free" sells better? The FDA would say no and make them change. Yet, the SEC allows fund companies to run actively managed portfolios and call them "index funds" even when the SEC itself says an index is considered to represent a particular market or sector of the U.S. stock market or the economy. A actively managed fund that sellect stocks using quantitative means and then weights those stocks so that the portfolio purposefully does NOT represent a market or sector of the U.S. stock market or the economy should not be called an index fund.

I am not against the products; I'm against the labeling.

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Last edited by Rick Ferri on Sat Jun 29, 2013 3:44 pm, edited 1 time in total.
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Re: SEC’s Definition of an Index Is Outdated

Postby btenny » Sat Jun 29, 2013 2:37 pm

Are you saying there should be some sort of Truth in Advertising for mutual funds? I sure know I am trying to figure out what are true indexes in many different bond categories to control risk in a raising interest environment.

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Re: SEC’s Definition of an Index Is Outdated

Postby YDNAL » Sat Jun 29, 2013 4:16 pm

Rick Ferri wrote:It is proper for a dairy farm to label "reduced fat" milk as "fat-free" milk because the term "fat-free" sells better? The FDA would say no and make them change. Yet, the SEC allows fund companies to run actively managed portfolios and call them "index funds" even when the SEC itself says an index is considered to represent a particular market or sector of the U.S. stock market or the economy. A actively managed fund that sellect stocks using quantitative means and then weights those stocks so that the portfolio purposefully does NOT represent a market or sector of the U.S. stock market or the economy should not be called an index fund.

OK, I get that.

What IF I create the YDNAL Market-Weighted A-named Public Companies Index ?
  • Certainly, it does not conform to the SEC definition to "represent a particular market or sector of the U.S. stock market or the economy."
  • Is this not an index ?
  • Is it misleading in any way to the prospective investor ?
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Re: SEC’s Definition of an Index Is Outdated

Postby Rick Ferri » Sat Jun 29, 2013 5:56 pm

IMO, most "strategy" index providers and the fund companies that licence their actively managed indexes ARE trying to deceive investors. Quantiative products have been around for decades. They were never be called "index funds" before. They were active management. However, low-cost market-tracking index funds continued to take more from active management. So, instead of fighting indexing, the active managers started saying THEY were indexers also. It's was a very clever marketing switch done with the full intent of confusing investors. Just look at the way they products are advertised. They're call "smart beta", meaning that market beta indexing is dumb, and "intelligent indexes" meaning that traditional broad cap-weighted indexing is ignorant.

The fees are significantly higher in these "strategy index" products. Not only does the fund company make more money per dollar under management, the index provider makes more money as well. So, deceive away. If investors don't understand the difference between traditional indexing and active management disguised as indexing, then they'll probably pay more for what sounds like a superior strategy.

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Re: SEC’s Definition of an Index Is Outdated

Postby SVariance1 » Sat Jun 29, 2013 6:12 pm

I think the SEC's definition of Index fund is reasonable. If companies are stretching the core definition of index fund, they should explain how their process is different. In my opinion, the product you mentioned is what I would call an enhanced index fund. Many years ago, while I worked for Lipper Analytical Services, we informally created a list of funds called enhanced index funds. This exercise was specifically designed to create a list of products that had index fund like characteristics but also had elements of active management.
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Re: SEC’s Definition of an Index Is Outdated

Postby Rick Ferri » Sat Jun 29, 2013 6:16 pm

Ha! You're one of THEM! :twisted:

Vanguard did the same thing. They used to call enhanced indexes "structured products". Now they're just called indexes.

I'm fully expect to lose this battle, but I'm fighting on anyway.

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Re: SEC’s Definition of an Index Is Outdated

Postby inbox788 » Sun Jun 30, 2013 1:42 pm

Which came first, the index fund or the market index? Historically, market indices existed before funds existed to invest in them because there was no investment style to do so and cost considerations. Over time, index investing became in vogue and mutual funds and EFT were developed to reduce costs and make the products more accessible. Once products were sold, investment companies figured out they could sell things by calling them index funds, so it seems they created index funds without a market index, or the fund became the index.

Going back historically, let's ask some questions:
1) What does the market index track? What are the inclusion criteria, and sometimes, despite the standard the dow and s&p500 claim, they're not written in stone (http://beginnersinvest.about.com/od/mar ... verage.htm, http://www.spindices.com/documents/fact ... 00-ltr.pdf). Even how things are calculated are adjusted, despite market cap weighing, do spin-offs (i.e. Kraft), bankruptcies, etc. accurately reflect what you think the index tracks? With the confusion and controversy in the trusted indices, who's to say a new index is better or worse?
2) Does the index fund accurately track the index? Over time? Over changes? Account for dividends? Currency exchange? (EWJ vs DXJ?)
http://finance.yahoo.com/q/bc?t=1y&s=%5 ... &c=%5EGSPC
3) Are the managers actively managing? How much leeway are they given from the stated goal? None (HOLDRS), very little (SP500), lots (small caps)? So much so they no longer resemble their stated goal?

ETFs and index investing began as a very narrow segment with fairly restrictive common understanding as to what they were, but as they have proliferated, they've become as broad as mutual funds over a much longer period of time. Whether the SEC reigns in on the current usage of these terms, it's ultimately up to the individual investor to understand what is they're investing in and bear the risk of that investment.
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Re: SEC’s Definition of an Index Is Outdated

Postby ofcmetz » Sun Jun 30, 2013 2:29 pm

I agree that the term "Index" makes many people think that an investment is a good choice. The broad and liberal use of the word has done harm by getting people to invest in things they shouldn't. Thanks for fighting the fight Rick.
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