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.”
Clicking the hotlink to market index on the SEC site brings up this definition. “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.”
The SEC goes on to describe a few major market indexes: Dow Jones Industrial Average (DJIA), S&P 500 Composite Stock Price Index, Wilshire 5000 Total Market Index, Russell 2000 Index, etc. With the exception of the DJIA, all of the examples are broad-based, capitalization-weighted indexes.
The SEC also recommends that people visit the NASDAQ index definitions website where more market indexes are listed. With the exception of a few Dow Jones indicators, all the market indexes on the NASDAQ website are broad-based and capitalization-weighted.
Unfortunately, the products that are being launched today as index funds do not fit the SEC’s definition. Here is the investment methodology of the Dynamic Market Intellidex Index, which has been tracked by the PowerShares Dynamic Market Portfolio (ticker: PWC). The SEC approved this index-tracking ETF back in 2003. Does this investment methodology sound like the SEC’s definition of a market index to you?
The Dynamic Intellidex OTC Index (DYO) is a modified equal dollar weighted index composed of 100 stocks selected quarterly from the universe of the one thousand largest stocks, by market capitalization, quoted on the NASDAQ national markets based on a proprietary quantitative method. The Intellidex Quantitative Model, through sophisticated quantitative analysis, reviewed over 150 individual factors to determine which are the best predictors of future returns while identifying stocks that can deliver alpha or excess return with no additional risk. Overall, 47 factors were found to be statistically significant independent variables in determining the best stocks across the nine sectors in the Intellidex family, with each sector utilizing seven to fifteen factors.
The result of the SEC’s 2003 decision to allow PowerShares to call their product an index fund changed the definition of what a market index is and created a new chapter in the ETF industry. Literally, any investment strategy going forward could be called a market index, if there was a standard methodology, and any fund following this strategy could be marketed as an index fund.
Today, dozens of financial firms have introduced hundreds of active investment strategies that are being called indexes for marketing and licensing purposes. These methodologies are purposefully non-market tracking in their strategy and often bear no resemblance to a market by SEC definition. To muddy the water even more, ETF companies that track these indexes often use words like “enhanced index,” “intelligent index,” “smart index,” “next generation index” and other clever marketing gimmicks to suggest these active strategies will outperform market indexes.
In my opinion, this has made indexing more confusing to the average investor, and that’s exactly what the ETF companies want. The more perplexed investors are about index product difference, expected risk and return, good index and bad index, etc., the more traction ETF firms get and the more they can charge for their funds.
I do not think the SEC should have allowed PowerShares to call their ETF product an index fund back in 2003. I recommend that the SEC either re-categorize non-market index products as strategy indexes rather than market indexes, or at least add to the definition of an index on their website. Making one of these changes would alleviate what I think is confusing to investors and would be in the public’s best interest.
