Index provider role may cross advice line

Mar 12, 2007 @ 6:41 am

By David Hoffman

NEW YORK — As indexes developed specifically for exchange traded funds proliferate, so do concerns about potential conflicts of interest that may exist when index providers reach for extra performance.

The fear is that index providers, in an attempt to grab lucrative ETF licensing fees, could find themselves chasing returns rather than “trying to represent an asset class or strategy,” said Jim Wiandt, president of Index Publications LLC in New York.

To some extent, that’s what some industry experts believe is already happening with the advent of more indexes that have a quasi-active bent.

They point to the development of such “intelligent” indexes as those that underlie ETFs offered by PowerShares Capital Management LLC in Wheaton, Ill.

PowerShares does not believe that the indexes underlying its ETFs chase returns or cross the line into active management, said company president Bruce Bond.

While the indexes its ETFs follow aim to add value, they still are rules based and will not deviate from those rules, he said.

Pushing the envelope

PowerShares isn’t the only firm that some believe is pushing the envelope.

First Trust Advisors LP in Lisle, Ill., has plans to roll out a suite of ETFs pegged to AlphaDex indexes, described in registration statements as “custom enhanced.”

The AlphaDex indexes are also rules based, said Dan Waldron, senior vice president of First Trust Advisors. What he believes is giving some industry watchers pause is that they seek alpha, but that doesn’t make the index publisher the adviser, he said.

Even regulators are trying to determine the point at which index providers become investment advisers.

“It’s very difficult to draw lines,” Michael W. Mundt, senior special counsel for the Securities and Exchange Commission, said at the ETF Evolution 2007 conference in New York last week.

“It is an issue the industry could focus on,” he said.

The SEC is right to be concerned, said Jim Lowell, the Needham, Mass.-based editor of Forbes ETF Advisor, a monthly newsletter.

“If you’re an index provider, your business depends on the revenue stream to the adviser licensing that product,” said Mr. Lowell, who himself is working on coming out with a group of ETFs. “That is not an independent relationship; it’s co-dependent.” Some index providers are aware of the potential for conflict.

“We’d like to think that an arm’s-length relationship [will] keep us out of the view of regulators,” said Jerry Moskowitz, president of FTSE Americas Inc. of New York.

That said, it wouldn’t be “terrible if someone told us what an index is and what [it’s] not,” he said.

As to whether index providers should be registered as financial advisers, Mr. Moskowitz said that as long as they are providing a legitimate index with predictable returns, they should not be considered advisers. “I think it’s foolish, myself,” John Prestbo, editor and executive director of Dow Jones Indexes, a unit of Dow Jones & Co. Inc. of New York, said about the idea of a legitimate index provider’s being considered an adviser.

And for now, it appears that ETF products are on solid ground.

Mr. Mundt raised the issue only so that the industry would be aware of it and didn’t think that any index providers had yet crossed the line to be considered advisers.

But Andrew H. Corn, chief executive of Clear Indexes LLC of New York, said he isn’t so sure.

It could be argued that even such index providers as Standard & Poor’s Corp. of New York use “arbitrary” measures when constructing their indexes, he said.

“My opinion is that they should be advisers,” said Mr. Corn, who also is chief executive of a New York asset management firm, Clear Asset Management LLC.

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