Interview with Senior TABB Group Analyst Adam Sussman

Adam Sussman, a senior analyst with TABB Group, is the author of "Performance Anxiety: A Buy-Side Study on Benchmarks and the Investment Process." The report, published in December 2007, offers an exhaustive look at the index industry. IndexUniverse.com assistant editor Heather Bell recently chatted with him about his findings. You can read our review and summation of the study here.

Index Universe.com [IU]: What prompted this study?

Adam Sussman [Sussman]: We saw two different trends in the industry that we wanted to explore. The first was the rapid growth of ETFs and their use by institutional investors. The second was that the pension plans are taking a fresh look at how they measure their performance and the performance of their managers. Between both of those two major trends is the index industry. We decided to go out and speak with the pension plans about how they use indexes to measure their performance and talk to the index managers about their use of indexes and what they get out of it, both from the perspective of managing money for pension plans as well as running index products such as ETFs and some of the mutual funds. We just wanted to get some firsthand insights into those trends.

IU: Did you see yourself coming at this as an insider to the index investing industry or as an outside observer?

Sussman: We try to be neutral. We were coming at it from a blank slate and saying, "Let's talk to the pension plans, let's talk to the investment managers about indexing and about their use of performance measurement and see what they have to say." Of course, whenever you're starting a project like this, you have to have a hypothesis in order to generate the questions that you're going to go and talk to folks about, but we were trying to start off with as much of a blank slate as possible.

IU: What did you think were the most interesting findings? Was there anything that was surprising to you?

Sussman: The fact that 70% of the pension plans were going to be using customized benchmarks by 2009 was a big number. We knew that it was a trend, especially among some of the larger public pension plans, but the fact that the rest of the institutional world was following in lockstep with some of the larger guys to that degree was a surprise. I think that it signals a broader adoption of some of the alternative asset allocation models that are spreading like wildfire.

IU: The report discusses the growth of custom benchmarks. Is this a new area for index providers to expand into or is this something that the pension plans and people using those customized benchmarks are going to be generating themselves?

Sussman: I think that from an indexer perspective, whenever you see a trend, if you believe that trend is somewhat rules-based, you're going to look at it and see if you can turn it into an index. That's pretty much the product development life cycle there.

In terms of customized benchmarks, I think there's an opportunity to slice and dice the world a little bit more to create performance-based benchmarks. Now whether they can turn those into indexes with actual underlying securities that could then be packaged into a fund or an ETF is questionable, because these customized benchmarks that the pension plans are using are mixing different asset classes and different types of investment managers. But I think there's opportunity in coming up with performance benchmarks based on data collected from enough pension funds that they can measure themselves on a pure universe basis, instead of just using a customized benchmark and not really knowing how they're doing versus other pension plans that are using very similar benchmarks.

IU: Is the demand for customized benchmarks more a result of divergent investment goals or more a result of pension funds trying to manage their funds according to their unique liabilities?

Sussman: It's a little bit of both. I would say historically the latter is more true, so depending on what your liability situation is will determine how you're going to allocate your assets, which would then in turn require a more tailored benchmark. Moving forward, as the pension plans invest in alternative assets and they're looking at everything from private equity, hedge funds, real estate, adopting instruments like long-duration interest rate swaps, I think it has less to do with the variability and liabilities and more to do with needing a better way to measure the performance of their investments.

IU: Early on in the report you compare indexing to the Blob, "absorbing everything in its path and leaving nothing but low-priced investment vehicles in its wake," which made me laugh. I was wondering if you could discuss that concept a little bit.

Sussman: The concept is that there is a linear progression where the first step is someone coming up with a unique investment idea that no one else has come up with. In the second step, if that new investment strategy is successful, other people will try to copy it. As more and more people try to copy it, there's more information about what that strategy actually is, and once it becomes well known what the rules are involved in that strategy, an index provider can come in and can replicate it and create a real securities-based index around it. Once that happens, then you can create index funds that will offer that investment strategy at a reduced cost.

Also along this linear progression is the reduction in management fees and related fees for that particular strategy. A good example these days would be some of the more well-known hedge fund strategies. Maybe five to seven years ago, academics were able to go back and figure out mergers and acquisitions arbitrage. Everybody understands how M&A arb works, and so you had academics go back and say, "Hey, let's see what the average performance would be if we executed every single possible M&A arb opportunity."

They did that and they calculated a return, and it's very clear that if the academics were able to go back in time and be able to do that, every time an M&A deal is announced moving forward, if you were an index manager, you could execute on that. If there isn't an index product out there that captures that, I would expect one to be imminent.

All sorts of other investment strategies could be understood in a similar way, so that's what I mean by "the Blob." No one is immune to it as long as it's a rules-based strategy. The only investment strategy that would be immune to being "Blobbed" would be if it was someone trading on intuition; otherwise, no matter how complex it is, eventually you can encapsulate a set of rules and run it forward.

IU: You touch on socially responsible investment in the report. Is that going to be a growth area for index providers, and is that how a lot of assets are going to be directed in the future?

Sussman: It's grown already so much, and I think that as those types of products become available in defined contribution plans, that more and more people are going to allocate their assets that way. For the socially responsible providers, it's really a question of distribution. They can create all the products they want, but if it's not easy for the retail investor to get at them, it's going to remain an institutional product. The assumption behind the growth is that it's going to become more widely available in retirement plans and there's going to be more of a marketing push behind it.

IU: You had said that there was a chance now, because of the ongoing changes in the MSCI indexes, for other index providers like Dow Jones or S&P or FTSE to take market share from MSCI. What are the key points of differentiation where they would need to distinguish themselves to get customers to switch index providers?

Sussman: That's the challenge, because the differences between them are shrinking. It has to do with how they define capitalization, how they define sectors and industries, the consistency behind how they view all of these across different geographies and how they normalize definitions of capitalization. It's not as nice and clear with overseas companies as with most companies here in the U.S.

It's also really the intellectual capital that goes into how the providers structure their indices. That's the main one—and what are the advantages. People obviously point to things like performance and things like that, but for most of the standard market-cap-weighted indices, that's not really something that you can argue on.

Also, there is investability and the different products you can use to capture an index's returns. Those are the ways that the index providers are going to try to create differentiation.

IU: What do you see as the most important areas in which a successful index provider needs to excel?

Sussman: It's branding, marketing and relationships. If I'm trying to get pension plans to adopt a new set of indices, it's really reaching out to the investment consultants, the pension sponsors, the investment managers. It's a huge undertaking because they're not apt to change providers very quickly. You can't just cut prices and expect someone to move over, so it really is an intellectual campaign more than anything else.

IU: How important are analytics going to become? Is that full-service package going to be a determining factor?

Sussman: It's interesting. You can look at MSCI Barra and see that as an indicator that they think that there's going to be some synergies there. However—and this is just anecdotal—it seemed like within the same firm, people were already using MSCI and Barra, so it may be that the merger between the two companies was really more about cost synergies than growth. There really isn't anything you get out of the public filings that would confirm or deny that hypothesis, but just based on the conversations I had with folks, that seemed to be the case.

However, I think the opportunity is increasing because of the number of quantitative managers out there, and obviously the underlying constituent data for indexing is an important component in the models that a lot of the quantitative strategies are based on. If you look at the recent acquisition of ClariFI by S&P, that's another move where I think they see some opportunity within the quant space. It's really about the indexers going out and looking at different analytics and different software packages that are in and around the quantitative/indexing space.

IU: How important do you think the smaller index providers are as drivers of innovation?

Sussman: I think everyone has been pretty innovative and everyone's been pumping out thousands of indices, but when you get outside of the cap-weighted indices, we have seen some real innovation from Research Affiliates, WisdomTree, and Ocean Tomo with its patent-driven indices.

I think there's room for innovation, but I don't think that's impacting institutional investors and their choice of indices because those indices that the institutional investors are looking at are really about trying to capture the largest opportunity set. The innovation coming from the smallest companies is really characterized by two things: 1) They're creating the index as a marketing tool to show where their research strengths are, and 2) The indexes are more geared towards the retail investor.

IU: When you were talking with your different sources, did you get any indication of what asset classes or regions are the new areas of interest?

Sussman: Well, anecdotally I can tell you that, based on some hedge funds that we've been talking to over the last couple of months, there continues to be increased interest in Asia and in emerging markets. That's an old story, but it's a story that's just continuing to play out. However, there are a number of people that are contrarian and are already shifting funds back to the U.S.