You've probably heard of us with the ASX 200 and hopefully with the S&P 500. We have a

series of committees that oversee our indices make sure they follow the rules, and I chair

a number of those committees including a couple big ones in New York and for a long time,

I did chair the one down here in Sydney for the S&P ASX 200.

What's probably my best investment first of all, wasn't in stocks and wasn't indices at

all. Back in 1974, when New York City had a financial crisis and everybody thought the

city was going to go bust, my wife and I bought our first apartment, and most everybody who

heard us do that or knew we're doing it the were lunatics for doing it. But we made out

very nicely about 11 years later when we sold it and rolled all the money into a bigger

one, so we'd have room for our kids. That was by sheer luck maybe a great investment.

Joe : I'm Joe Dickson from ASX, and today, we're talking about the power of the index.

Joining us today is Dr David , chairman and managing director of the Index Committee at

S&P Dow Jones indices. And David's going to explain to us what an index is, how they're

create it, how companies get into the index and what it means if they get removed from

the index. Thanks for joining us David.

David : My pleasure. Good to be here.

Joe : Let's start at the beginning. What is an index and what's its purpose?

David : An index is a list of stocks. You need a rule for what's in and what's not in,

and you also need a rule about how they're weighted. Are they all weighted the same,

by size, or by something else. And with that, you can tell what's going on the Stock Market.

And probably the original use, and I think still a very big use, is an index tells you

what's happening the market. The ASX 200 tells you did it go up, did it go down yesterday,

did it go way up, did it bounce around, it tells you what happened.

But increasingly, probably in the last 30 to 40 years, there's been a whole another

use for an index which is growing and is now very important. And that is, you can build

a financial product, like change [inaudible 00:02:28] that you and I and anybody else

can invest in, that tracks the index. And it turns out to be a very effective and efficient

way to have a way to invest in a home market, or particular part of a market do very well.

What then happens, [inaudible 00:02:43] expenses on top of that.

Joe : Sounds like there's a fair bit of history in indices. Just pause for a minute, take

a step way back, company you work for's been involved in index for a long time. Can you

tell us a bit about the origins of the share market index please?

David : The first one, it's certainly the first one that's still around, was in the

United States and that's the Dow Jones industrial average-

Joe : Yeah I think most people have heard of the Dow Jones, yeah-

David : Absolutely. We hope so anyway, part of our name nowadays. The Dow started back

in 1896 and beginnings of the Wall Street Journal newspaper ... beginning of the newspaper

they wanted a way in one number to tell people that the stock market go up or down.

Joe : So this would help them sell newspapers possibly?

David : It definitely helped them sell newspapers. In fact, the S&P 500, or really its predecessors,

were created for the same reason. It was ... in those days Standard and Poor's sold a lot

of information at the Stock Market, and to sell more, they invented an index now called

the S&P 500. And if you go through a lot of places around the world, this story is the

same. Financial Times, the FT 100 started with that newspaper. And a lot of newspapers

over time gave up their indices because it was easier, and they got more bang by using

somebody else's index like the S&P 500, or I would guess here in Australia, like the

S&P/ASX 200.

Joe : Well let's talk about [crosstalk 00:04:13] yeah let's talk about Australia. S&P Dow Jones

look after the index calculation, just quickly give us a summary of the main market indices

for Australia please, David.

David : The number one item, the one that's most widely quoted is, the S&P/ASX 200, it's

200 large liquid stocks. It really gives you the centre core of the market. But for an

investor looking at that, some investors may want fewer than 200 stocks, they don't want

just the large ones but the very large ones, others may want small stocks, others may want

to only real estate stocks and so on.

So we sort of slice it up and dice it up in six different ways. There is an S&P/ASX 20,

50 and 100. 20 is the 20 largest stocks, 50 is the next 50 including the 20, and so on.

200 is really the key item. When you get to 300 stocks, it's a very broad range of the

market and that's sort of description to the overall market. Although there is, to use

an older tradition and all ords which is, I think, 500 stocks, [inaudible 00:05:21]

anything that's out there.

Joe : Yeah, the all ordinaries index. That's right.

David : Depending on what pieces of the market you wanna look at, an in fact, people do things

like, take the 300 but then illuminate the 100 biggest stocks, then get the next 200,

which is sort of the middle section. We're also splitted up by industry. Natural resources

is a major factor in Australia, real estate is another major factor, or divisions, which

we use around the world, things like financials or healthcare, industries that repeat from

country to country.

Joe : From what I understand, indices are extremely powerful for companies and so when

a company is listed on ASX, or any exchange around the world, they're inclusion in a particular

index can have a big bearing on how much research gets conducted on them, how much interest

is there from different investors. S&P Dow Jones index, and the index committee, must

have a lot of power in determining which companies go in which index. Take some time. Can you

explain to me what your decision process, or the rules-based framework that you use

to include companies into an index.

David : The indices here are very much rules based. And we look at the stocks by ranking

them by size. Size in this case means what we call, "float-adjusted market cap."

Joe : Float-adjusted market cap?

David : Yes. When you look at an index, you wanna look at not just the value of the shares

on a market, and how many shares there are on the market. What you wanna look at are

the ones that are really on the market.

If you've got a company where the founder, or the family of the founder, if was founded

three generations ago, could say, owns 20% of the stock, and they're not gonna sell it.

It's their heritage, almost. That's not on the market, they gonna hang onto their 20%

through thick and thin. We're gonna look at the other 80% that is on the market. And when

we say float-adjusted, we don't count the 20% that's held by the family.

In some countries, the government will own a huge block of the stock. The government's

not gonna trade it because the stock went up or down, they're the government, so we're

not gonna count that holding in the same way. We look at the float-adjusted market cap,

which is a much better measure of what that company means to the market. And as an aside,

if you had a company where 90% is held either by the government or the founding family,

or three people in the board of directors. That stocks really not very big impact in

the market, even though it may sound big. That gets shrunken down.

First we look at size, and second of all we look at what we call, �Liquidity.� How

much it trades and how much trading activity there is. We don't wanna stock where somebody

comes in and buys 1000 shares. The thing suddenly pops up because not much is tradable. We wanna

stock that's quite liquid, instead if somebody busy 10,000 shares, it barely wiggles, because

one investor shouldn't be able to create turmoil in the market.

We rank them on size and liquidity, and we start at the top and the first 20 of the ASX

20, 50, from number 1 to 50, to the ASX 200 is gonna be the 200 stocks. Number 200, cause

markets fluctuate, it may be number 199 one day and three days maybe number 202, and then

195, and then 210. You don't wanna keep throwing them and putting them back in cause they bounce

around a bit. We have what's called a buffer which means we leave a little wiggle room

above and below the 200 mark so that we don't have to keep throwing people out or putting

them in and creating turmoil when they shouldn't be there.

Joe : That's a really important part that I wanna talk about next is that the companies

down the bottom of the list, on whatever size index, and I hear about quarterly rebalancing,

and rebalancing means something that can have quite an impact on a company. If a company

gets rebalanced or removed from an index, why would it be removed, and can you give

us some insight in what the repercussions might be for it?

David : One way I sometimes think about being on an index, being off an index, for company,

and at least for the S&P 500 where the rules are somewhat different and it probably has

bigger impact, is what I call the �List effect.� If you're on the list, certain

things happen. If you're not on the list, they don't happen. One of the ironies is,

being on the list you get a lot of attention, you probably get more securities analysts

paying attention to you, you may get more calls from reporters from financial papers.

And your name probably pops up on lists of potential acquisitions by bigger companies.

That's sometimes [inaudible 00:10:21] not always the best thing. But everyone always

seems to want in anyhow. If a company gets added, not overnight, but gradually over a

period of time it will get noticed. If a company gets dropped off, immediately people gonna

say, �Why, what happened? Did they do something wrong?�

When we do a rebalance, which every quarter, the index committee sits down and they go

through all the indices top to bottom, they redo the ranking, check the data. When we

announce that, we always say the index change or adjustment is not an investment opinion

because we're just following the rules. We're not picking hot stocks. In fact, I've been

doing this a long time, you don't want me picking hot stocks, I can assure you of that.

We go to great lengths to say to investors and analysts, �Look at the numbers, look

at what happened, see if you think our data is right.� But we're not telling you the

stock is a bad investment because its number dropped from 200 to 215. We're not telling

you some other one's a great investment because the number went from 215 to 195. We're telling

you, �That's where the numbers were.� And maybe some stuck went up to 100 that got

very big or very small, it sort of push the list around.

Joe : That's probably a good point. You're not making a judgement call on the investment

viability of a company, are you, when it's rebalanced?

David : Definitely not. We're sticking to our rules. Now, clearly there are unusual

cases where we're gonna do something right away. The obvious one's if a company gets

taken over in an acquisition or is in a merger or if unfortunately they file for bankruptcy

or something, we'll have to adjust the index when that happens. If they're de-listed from

the exchange, they're going out cause nobody can buy them so it's pointless to have them

on a list at that point. But otherwise, all the normal changes will get down at every

quarterly rebalance.

Joe : The S&P ASX 200 index will give us an indication as to the performance of the largest

200 companies on the market, but if investments aren't interested in the whole market, and

they just wanna look at banks or resources, do indices give us the ability to cut up and

look at those sectors individually?

David : They do. The whole market is made up of separate companies and whole bunch of

different industries and for any company in the index, we know more than just how big

it is in terms of market value, we also know what it does, what kinda business it's in.

We can take, say all the banks, and we'll make them another index. We might call it

a sub-index, that's just the banks. We can take real estate investment trusts, [inaudible

00:13:05], and make another index of those. And you can go through the whole 200 stocks

creating a bunch of indices and then you'll get ideas, �Banks didn't do as well as real

estate. Natural resources did much better last year than they did this year,� all

that kinds of things.

We can also spice it up in a different way, and that is some investors like to talk about

growth companies, sounds like you outta be there. Other investors might talk about value

companies which usually means the stock is going down and you hope there's a lot of value

in it. We can cut the market up, and the growth companies, and the value companies, and an

investor will say, �Well, this is a growth market, cause the growth companies according

to the split are doing better.�

By splicing and dicing the index, we can tell you all kinds of analysis or all kinds of

stories about what's happening in the stock market, and maybe to give you a better idea

whether you should be in the market or outta the market. But they gotta remember, there're

no guarantees in this business. Forecasting about the future really is very difficult.

Joe : For people who love to learn about the index, and wanted to learn a little more,

where would be the best place for them to go be?

David : I think the place to start ... we run a website with a whole lotta information.

I'm sure the exchange runs one as well. But among the things they'll find there, they'll

find a rather thick book made, if they have insomnia, maybe a good [inaudible 00:14:33],

called, �The methodology of the S&P ASX indices,� which will go through all the

rules, list all the indices, tell you what's in them, tell you how they work.

Joe : So it's transparent? The information's there if people wanna find it.

David : It is completely there. You should be able to, or an investor should be able