Episode Transcript
Bryce Clarke: They were looking to create a better tool to help understand and attribute where the performance was coming from. And is this manager adding value because they are doing the right things, making good decisions, or is it purely luck?
Lee Turner-Conn: Hello, welcome to this episode of FTSE Russell Convenes. My name is Lee Turner-Conn. I am Head of Americas Index Investment Group at FTSE Russell. And today I have with me Catherine Yoshimoto, the Director of Equity Product Management, and Bryce Clarke, Regional Director of the Index Investment Group. Thank you both for joining me here today. You both have over fifty years experience in the index world. And I'm very excited to talk with you about indexes and specifically about the Russell Indices in America.
So Catherine, you have always been part of the product side and building. Bryce, you have always been part of the client side and understanding what they need. Together we bring those two things and we build what are better products for our clients.
Bryce, can you tell me how the, what's your memory of how the Russell Indices and why they were formed?
Bryce Clarke: There were a handful of clients, one of them was one of the clients that I was working on, General Motors, that the Russell Research Group was doing a project for. And they were looking at managers and trying to find better ways to understand and attribute the performance of those managers. And a lot of these managers were investing in small cap stocks.
So, a gentleman by the name of Kelly Houghton and a group of the research people began, kind of, interviewing managers, really, and asking them what they think of is their buyable opportunity set. When they go out and look for stocks to purchase and hold in their strategies, Where are they looking? And what is the cap size of those stocks that they're looking at? And so they took this information back and what they found is that there were roughly two thousand names that these managers that were kind of orienting themselves towards small cap, were looking at.
And in the manager research group, they started kind of looking at large cap managers as well and found that there are about nine hundred to eleven hundred stocks that those managers purchased or looked at. And so that's kind of the start of how the Russell 1 and the Russell 2 came about because those were the areas of the market that these managers were looking for opportunities.
With that, Russell started using that information as they did manager research meetings. The consulting group started using those indexes in the reports that we were sending to the consulting clients and we started taking the S&P 500 out and for all these small cap managers, instead of benchmarking them to the S&P 500, putting the Russell 2000 for it, it made a lot more sense to Russell Consulting, to the clients they were working with, and ultimately, the managers in particular that were investing in small cap stocks, this made more sense to them for them to be measured against that, plus they performed better compared to that index than the S&P 500. And so they started using that with all of their clients also, outside of Russell. And that's really where the whole thing snowballed and started getting some recognition in the industry.
Lee Turner-Conn: Right, so it wasn't like, oh, we need a better index, per se, it was, we're writing a report for the clients here and the comparison isn't apples to apples. It isn't what we're really using, right? The clients were like, that's not how I determine what stocks use. And so from understanding what the client was trying to achieve or explain their story, they ended up creating an index and then realised, well, hey, this is actually the benchmark is what we're using.
Bryce Clarke: They were looking to create a better tool to help understand and attribute where the performance was coming from. And is this manager adding value because they are doing the right things, making good decisions, or is it purely luck?
Lee Turner-Conn: So now, Catherine, that all happened prior to you coming on the scene. So you came on at the financial crisis time. The Russell 1, 2, and 3 are set up, but what happens at that point with the product?
Catherine Yoshimoto: So 1, 2, 3 is there. And then growth and value also was an important Russell innovation developed in the 1980s, also an important part of the equation of measuring measures, skill versus luck.
The growth and value indexes, though, during the financial crisis, one of the metrics they used, the growth metric, they used the long-term growth forecast metric, was starting to see their analyst coverage drop.
Around the time I joined Russell in 2010, they were embarking on this research of what can we replace long-term growth with? And they found that the medium-term growth and a combination with historical five-year growth was an appropriate combination to replace long-term growth. However, it also increased turnover. So what they did also at the same time was to band the composite value scores. Over time, Russell implemented methodology enhancements, like the Russell 1000 and 2000 actually implemented size banding in 2007 because they found that they wanted to mitigate turnover between the two indexes. So it's kind of a continuation of that variation but applying to styles, but also addressing a problem where they saw the coverage dropping, so they replaced the variable, but found that the turnover needed to be adjusted.
Now that also post-financial crisis was a time where new factor research was going on. So quality and volatility were identified as potential factors to input into a new style dimension. So the third dimension of style became the Russell Stability Indexes. So they launched a defensive and dynamic indexes. But they found in speaking with the clients, the feedback was that the tracking error against the benchmark, the Russell 1000, for example, was too high. So they had to implement an additional methodology where the tracking error was controlled.
That meant that the weighting was adjusted. And so that also is another theme that was emerging, right? The original market cap weighting flow adjustment was Russell's innovation. And then equal weighting started coming into play, alternatively weighting, and then that was, I think, the decade post, when I joined Russell Investments, Russell Indexes, is they started looking at additional ways to reweight the market. Again, equal weighting and then tracking error control, now there's factor target exposure for factor indexes, and then now with market concentration, we're looking at capping some of the biggest weights in the indexes to address concentration concerns, constraints for some of our fund managers.
Lee Turner-Conn: You're coming on the scene and style is very important, and people are really getting deep in that growth value, but it just sounds like it was ever evolving. Like, what score do we use? How does this work? What were you doing at that time within a product role?
Catherine Yoshimoto: Well, we don't want to be tweaking constantly. Like, I want to correct that misperception, because we also want to be thoughtful about the changes we make. And today, as part of London Stock Exchange and FTSE Russell has a robust governance process, where we have to go through our index governance board and do a market consultation, a lot of structure around the changes in methodology. So again, we have to be really thoughtful about what we need to change, but then we do that in consultation with our clients and getting feedback into what could be improved. That's the important part of working with our clients and understanding what are the securities they can't hold, or what are the constraints they're working under, like the concentration requirements.
Lee Turner-Conn: I can imagine getting the client feedback is critical, and Bryce, that's where potentially, I guess, you come in, because you're facing these clients that use it every day. How often are you getting feedback on the indexes?
Bryce Clarke: We get a lot of feedback from the clients, particularly around the annual reconstitution. That's when a lot of questions will come up about when is it taking place, what's been the process, what are the changes that they can expect? So over time, we've done a lot to make that whole process more transparent. There have been concerns at times about people front running those that are passively invested in the index. So through the enhancements that Catherine was talking about, to methodology, and again, not to reuse the word, but transparent, being very transparent and thoughtful in our process, people can anticipate that. There are actually firms out there that will completely do the reconstitution ahead of us.
Lee Turner-Conn: Right, if you make it too transparent. Everyone knows what's going to happen, essentially.
Bryce Clarke: It's not the official reconstitution, but it does help the market understand what's happening. And again, it opens up the transparency. So people can't have as much of an opportunity to game the market, let's say. So as an asset owner, you can feel more comfortable that your investment in the passive exposure that you have, whether it's the Russell 3, the 2, the 1, or the growth or value, that you are still getting good exposure broadly to the market and that you're not going to have problems in that allocation.
Catherine Yoshimoto: And I think another way to look at transparency is that we're improving market efficiency, and that is beneficial to investors because then, they're getting the best price. And that's something we've also, Russell Indexes worked with exchange partners over the years, too, with NASDAQ and the Cosing Cross. Russell Indexes were the pioneers, the first to work with NASDAQ in 2004 to implement the Closing Cross at the single price for all the securities and the indexes so that nobody's being displaced by some of the price distortions. We've worked with the market, the exchanges, our clients to improve the transparency and market efficiency of the indexes. That's making a better product for our clients.
Lee Turner-Conn: I'm reminded of when I had a meeting with Bob Pisani on CNBC and he said, what do you want to talk about? I said, we should talk about Russell Reconstitution. And he said, “Well, but there's no news there.” And he's like, “There's not much interesting happening.” And I said, “What do you mean?” And he said, “Well, that's what you want. You've done this amazing job to make it so efficient that we know how it's going to work. There should be no surprises. And the market runs perfectly on that day.” I think it's something we're quite proud of, even if it means that I don't have a news story to tell, right?
I think that does a great job of taking us from how you both started, the client interaction, and then where we got to today, these really efficient, wonderful indices. Where is Russell developing product today, Catherine?
Catherine Yoshimoto: The market's constantly changing, and I think we're constantly keeping an ear out for what our clients are concerned about. Flexibility is something people say, how do people describe FTSE Russell, like how we work with clients, how we're willing to hear them out.
Some clients may want to exclude China from their investments, for example. So we've created emerging ex-China indices, excluding energy, for example, or now with AI concentration, people might want an energy-focused index, but then how you bring together all the impacted sectors, right? So it's thinking about variations of inclusion, exclusion, also re-weighting. So those are kind of, like broadly the techniques, I would say, that we will incorporate into creating new indexes, but also just getting feedback from the clients and see how we can solve their problems.
I was talking to a growth manager who was really struggling to beat the Russell 1000 Growth Index. And we're just brainstorming ideas. And I said, well, we have our Russell Top 50 Mega Cap Index. How about we exclude those stocks from the Russell 1000 Growth Index? And he said, no, it's actually more concentrated than that. Why don't you exclude the largest ten companies from the Russell 1000 Growth Index? And that will give me a way to explain performance, why I'm underperforming the Russell 1000 Growth, but not the Russell 1000 ex- Top Ten Growth Index. So we've built an index like that so that they can better explain and service their clients.
Lee Turner-Conn: Russell Indices are quite transparent and clear. So the rules are clear, and then therefore it's very easy to make up new rules to slice and dice them for customisation for a very specific need. And Bryce, you're getting those customisation requests, I assume.
Bryce Clarke: From the asset owner clients.
Lee Turner-Conn: How has that evolved in the last few years? Or give me some examples of what those questions are.
Bryce Clarke: You know, there's been a growth in passive management, and asset owners are always looking for ways to get exposures to various parts of the market, but do it in an efficient way, cost effective way. For a long time, asset owners were hiring active managers to give them maybe some exposure to momentum or value or quality. You can actually identify those factors and through creating rules around identifying stocks that have those characteristics in an index, you can create and replicate a momentum, a value, or a combination of factors. And so by doing that then, the asset owner can actually open up a fund or run the money internally and lowers their cost of implementation.
So they're not paying an active manager to basically give them an index fund. And then they can go hire the active manager to find that area of the market where they can use more expertise and skill to add value.
So either in small cap or particular segments of the market in industries or something. So those are some of the ways that asset owners are looking at and using some of these additional index tools. Other things come into play, such as sustainability.
And so how do you tilt towards companies that have sustainability? A lot of public pension plans have certain exclusions on tobacco or firearms or parts of the market, coal, that they want to have those segments of the market or industries excluded. And so we do a lot of customisation there for clients as well.
Catherine Yoshimoto: And I think it's also important to highlight, we're not trying to replace active managers, that we are there as a complement. And Bryce is describing how asset owners are using the passive index-based funds where they can, but then using active managers to add value in different, less efficient parts of the market.
Lee Turner-Conn: When clients are working with FTSE Russell, what is the one thing that they want from us to make better indexes?
Bryce Clarke: They want us to listen to them. And they want us to collaborate with them and work with them to help them have better tools and be able to make better decisions. And that's where the Russell Index has started, is the idea of having a better tool to help make better decisions for the benefit of the pension plans and the participants in those plans.
Lee Turner-Conn: So understanding their needs.
Catherine Yoshimoto: Clients want to feel like they're being listened to. And so it's not just the dialogue, but then having something at the end of that to help them, a practical solution that helps them with their investment.
Lee Turner-Conn: That makes total sense. Well, thank you both for joining me here today. I know I have learned a lot more about the Russell history, and I have a lot of ideas about how we can have clients in the future. Thank you.
Bryce Clarke: Thank you.
Catherine Yoshimoto: Thank you.
