Morningstar Advisor - December 2013/January 2014 - (Page 56)

Morningstar Conversation you ever considered having a benchmark that has far more turnover? In other words, have you considering making a benchmark that's not investable but that is a very good representative of what the actual space is? Subramanian: We provide indexes from very broad-based market composition beta to something which is long-short, much more factor purity. We call it pyramidal beta. So as you go from the broad beta to anything which is much more purity in signal, you find that, although you're obtaining a purer signal with different types of beta, you lose some capacity and lose some investability, when investability means that you don't have to frequently rebalance everything. Craig Lazzara, left, and Raman Subramanian at the Morningstar ETF Invest Conference This brings us back to the importance of independence in index providers. Changes to the S&P 500 are driven by a committee that is concerned about the integrity of the index, not about a manager who is concerned about running a portfolio. Investors can have a relatively great degree of faith that indexes are being managed in the interest of the indexes themselves and the owners of those indexes as opposed to the managers of index portfolios. Subramanian: Index providers have brought the best practices of self-governance inside their organizations. One aspect of this is the governance-based index committees, but then you make sure the methodology is transparent and nobody's front-running it. So if you have best practices built in the entire index construction process and you have of a level of oversight that is also built inside, then the concept that indexes are moving markets is probably made up. But having said that, we probably require some sort of an independent authority or somebody who's actually overseeing the best practices. There is an industry alliance which has 56 Morningstar Advisor December/January 2014 been formed. I don't know whether many of you know that there's an industry alliance for the index providers. It was a launched a couple of years ago. What they have done is that the compliance within each of those organizations have come together and formulated the principles on which the indexing world should operate-what are the best practices. The question is whether there should be an independent SEC kind of organization overseeing us. That is left to debate. Some people say yes, we want it. Some people say no, we don't want it. Viewing Investability Johnson: We'll pause here and take a question Momentum's a good example. We have a more broad-based momentum index, which is rebalanced semiannually. But we also have a long-short 130-type of momentum index, which is rebalanced on a monthly basis. The annual turnover of the broad-based index is roughly 50% to 60%. The annual turnover of the one that offers more purity in that space will probably be upward of 100%. So, if you own a hedge fund, which can charge two and 20, you can limit that 100% turnover. But if you want to create a passive replication product, then you may want to limit the purity in the signal, but ultimately you don't want to have a performance drag eating up all the alpha that is sitting in the benchmark itself. So, that's a tradeoff. So, as an index provider, we have provided all the flavors of what we call a pyramid of beta. The investors pick what is right and appropriate for them. from the audience. Audience Member: You've mentioned the difference between an index and a benchmark-that an index is an investable strategy and a benchmark is representative of what that space did. You've spoken about them as two separate things. My question is, have Lazzara: I want to be a little rude, and I'm going to disagree with the premise of the question itself, if I may. To me, a benchmark is obviously a standard by which you will evaluate an active manager. The desirable characteristics of a benchmark are that it encompasses the universe from

Table of Contents for the Digital Edition of Morningstar Advisor - December 2013/January 2014

Morningstar Advisor - December 2013/January 2014
Contents
Contributors
Letter From the Editor
What’s Your Purpose?
Working for Gen Y
How to Allocate College Savings
Mobius Looks to a New Frontier
Investments á la Carte
Investment Briefs
How to Manage Bonds for Today and Tomorrow
Cloud Is the New Engine of Growth
Knowing Where to Look
Economic Vulnerability Varies by Country
Factor Investing in Emerging Markets
Following the Rules
Exploring Indexing’s Next Frontiers
Frequent Fliers
Family Blind Spots
Optimal Portfolios for the Long Run
Finding Value in a Pricey Sector
Our Favorite Mutual Funds
50 Most-Popular Equity ETFs
Undervalued Stocks With Wide Moats
The Emerging-Markets Roller Coaster

Morningstar Advisor - December 2013/January 2014