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From AJR,   October 1999  issue

The Index Reflex   

More and more news organizations are creating stock indexes to monitor an industry’s performance. They have to tread carefully to avoid conflicts of interest.

By Kara Newman
Kara Newman is a financial writer living in New York.     

It's 9:30 on a weekday morning, and the opening bell for the stock market has just sounded. The floor of the New York Stock Exchange hums with the electricity of stocks trading, traders shouting, fortunes to be made or lost in minutes. Quick! What is the market doing?

For millions of investors and journalists, the answer lies in a stock index. "Imagine trying to tell the story of the market without the right measure," says John Prestbo, editor of Dow Jones Indexes, a unit of Dow Jones & Co. "It's like a writer looking for the right word," and not having it in her vocabulary.

For generations of business reporters, telling the story of the stock market just wouldn't have been the same without the most storied stock-market measure of them all: the Dow Jones Industrial Average. Investors and editors use the average, which conveniently tallies the performance of 30 of the largest and best-known stocks, to get a handle on the market's performance in a given period.

But the old Dow Jones has a slew of competitors trying to muscle in on its turf. They include financial media mainstays such as the Financial Times and McGraw-Hill's Standard & Poor's, and some notable newcomers, such as Wired magazine and TheStreet.com, an online financial news service. News organizations are using knowledge of the market that they accumulate each day to put together a hit parade of stocks expected to perform well, or simply expected to reflect the movement of a particular industry.

The proliferation of stock indexes among media outlets raises a number of ethical questions for organizations that have made a name through objective reporting on business-related issues. What is the appropriate relationship between the news reporting and the index-maintenance parts of the organization? Are editors qualified to help decide which stocks become part of the index, and, if so, will their decisions affect how those stocks are covered in the news publication? Is it acceptable for the editorial staff to invest in the index components, either individually or through mutual funds? Can reporters write about stocks they own? And will there be safeguards to prevent conflicts of interest?

With all these questions, why would news organizations want to become involved with setting up stock indexes, anyway?

The motivations are basic: to help publicize a company's brand name and to earn money.

It's been demonstrated a stock index can raise a company's profile. Even if you don't use a Dow Jones wire feed or read the Wall Street Journal, you probably know that "the Dow" refers to the Dow Jones Industrial Average. Similarly, most international investors know that "the Footsie" refers to the Financial Times' FT-SE 100 Index, another one of the most widely used measures of stock market performance.

And a news organization potentially can raise a great deal of money in licensing fees if a stock exchange or investment firm creates a tradable financial instrument using the index. A license gives the exchange the right to create financial instruments using the name of the media outlet (such as Dow Jones or Standard & Poor's) and using the stocks that make up the index.

Of course, setting up an index does not guarantee instant income for a publication, even if that index is licensed. Some indexes fizzle, while others become lucrative.

Among those indexes that have seen a hefty return is Standard & Poor's. An S&P representative estimates that the annual licensing revenues from all of its U.S. and European indexes total about $50 million. The figure doesn't include fees from data sales related to the index.

The key is whether an index becomes the standard by which performance is measured. In many cases, landing a lucrative licensing contract from a stock exchange or investment firm depends on having an index that blows away its competitors in its niche by being the broadest, the narrowest or the most accurate measure--or the most cutting-edge concept. In the index race, fourth or fifth place might as well be last.

The Wired Index is a prime example of a cutting-edge concept fund. The magazine touts its index as the "bellwether for the new economy." It's composed of technology-savvy, forward-looking companies such as America Online, Microsoft and Sony, which are among those Wired magazine covers. The index was released in June 1998. Guinness Flight Investment Management (now Investec Guinness Flight Global Asset Management) then approached Wired about setting up a fund based on the index, and launched it in mid-December. Investors plowed about $63 million into the fund during its first three-and-a-half months of existence, says Jim Atkinson, the U.S. director of Guinness Flight.

But the path from independent index to cash cow is fraught with uncertainty. The business of creating financial instruments from indexes is relatively young and has only recently gained legitimacy in the eyes of many investors. For instance, up until two years ago, there was not a single tradable product based on the century-old Dow Jones Industrial Average. Although overtures had been made to Dow Jones as early as 1982 to set up stock "index futures" on the benchmark Dow average, all offers initially were declined. "They were brand new, and Dow Jones didn't want to risk the Dow Jones Industrial Average in an enterprise we weren't familiar with," says Prestbo, who is involved with overseeing the content of many Dow Jones indexes.

He explains how stock index futures work: The futures create a contract to buy or sell the value of the stock index--in this case, the Dow--at a specified price, on a specified date. For example: One could buy an option to purchase the value of the Dow Industrial Average at $10,000, which would be a bargain if the average was $11,000. One could then exercise the option to buy the Dow Average at $10,000, turn around and sell it at $11,000, and pocket the difference.

By 1997, regulatory procedures had been tightened considerably and the trading of index futures and other financial instruments had become widespread. At that point, "we decided we should make the indexes a commercial enterprise, as well as a journalistic one," Prestbo recalls. There is now a dizzying array of products available based on the Dow Jones Industrial Average--including funds and futures.

How are indexes created? Much like journalists use a "news peg" to make articles relevant to readers, stock indexes usually are created around a timely theme to help spark investor interest. Right now, the lion's share of new indexes revolve around the burgeoning world of the Internet and e-commerce, as well as the so-called "euro-zone" created by the European Union's launch of the euro on January 1. But investors are notoriously fickle; six months down the road, biotechnology or emerging-market indexes may be in vogue.

Creating a stock index is generally a low-cost venture, although marketing that same index to the public or potential licensees can be pricey, publishers attest. Usually, a group of financial editors select a group of stocks that they believe to be representative of a particular industry or market sector. In many cases, the basket of stocks is chosen with some preset criteria in mind. The editors may select stocks for their sound balance sheets and environmentally responsible management, or stocks that derive a significant amount of their revenue from the Internet. Sometimes the editors enlist the help of professional analysts to help decide which stocks should make the final cut.

By some accounts, indexes created and run by independent news organizations have an edge over those developed by financial services companies. An index created by an independent nonfinancial company such as Dow Jones or Standard & Poor's is viewed by institutional investors as easier to trust than one created by a financial company, which for many users also represents a competing investment bank.

Furthermore, news organizations are accustomed to disclosure and standards of openness about how research is conducted. Financial companies generally are less forthcoming about what standards are used to select index components and tend to regard index creation and maintenance as proprietary information. In contrast, news organizations thrive on disseminating information. Most freely publish their guidelines and procedures for picking stocks.

When media outlets create stock indexes, one of the stickier issues is ensuring that journalistic objectivity does not suffer, especially when it comes to covering stories about companies listed in the index.

"Every publication has a responsibility to set clear, reasonable guidelines for its reporters on matters that may present a conflict of interest," says Robert Steele, ethics group leader at the Poynter Institute for Media Studies in St. Petersburg, Florida. "These guidelines may involve reporting on or writing about financial issues in which the individual journalist has some stake, or [they] may involve a financial issue in which the news organization has some stake or connection." Good news organizations, he adds, "create clear, thoughtful guidelines that serve the public interest, respect the employees of a news organization and protect them from a blindside error, and...honor the principles of the news organization itself."

For some of the larger companies with far-reaching licensing deals, such as Dow Jones and the Financial Times, the solution is to create a separate company to manage index-related products, or to hire another company to do the job. For example, the Financial Times and the London Stock Exchange co-own FT-SE International, a separate organization from the Financial Times newspaper. But the delineation is not always clear-cut: editorial and index management operations frequently overlap.

Even in cases in which the publication is hands-on when managing and creating indexes, products based on these indexes, such as index funds, are almost always managed by a separate organization, usually a stock exchange or investment firm. For example, Wired magazine maintains the Wired Index, but the Wired Index Fund is run independently by the asset management firm Guinness Flight.

Even with these precautions, how does a publication ensure that reporters aren't buying and selling index components ahead of published news reports on activity--the editorial equivalent of insider trading? Without adequate precautions, it could be easy for a writer to buy shares of Intel just before the stock is added to an index or just before a positive story about the stock is published, and then cash in as the stock moves higher. Obviously, one solution would be to establish strict barriers between the editorial and index management departments. Another, more extreme method would be to forbid editorial employees from holding any individual stocks, period.

A third solution, which Dow Jones uses, embraces restrictions and disclosure. "There are no restrictions on reporters covering [index components]," says Prestbo. But reporters are not allowed to hold stock in any companies they cover, and every editor, reporter and ad salesperson is required to sign an annual conflict-of-interest statement indicating that they have not violated this rule.

Some reporters at other organizations chafe at the restrictions imposed on editorial staff. "The stock market is what I deal with all day long, and it's what I know best," says one reporter, who spoke on condition of anonymity. "I know that these restrictions are for the sake of objectivity, but I still resent the restriction on my personal financial life. If I wrote about food, would there be certain things I wouldn't be allowed to eat? If I covered fashion, would there be certain things I couldn't wear?"

Wired employees may invest in the stocks they cover, including Wired Index components, but are expected to disclose such holdings to readers. "There are no hard-and-fast rules, but we need to know that," says Brad Wieners, a senior editor at Wired magazine and member of the steering committee that puts together the Wired Index.

Not only do such rules protect investors, in some cases they free up financial reporters to cover the stocks and indexes more objectively. TheStreet.com, which launched its own Internet index in November and E-Commerce Index in February, is refreshingly candid about the fact that reporters are not involved in selecting some index components. And the Web publication's reporters occasionally poke fun at which stocks make up the indexes: "TheStreet.com's reporters had no say in creating the new TheStreet.com E-Commerce Index," read one online article. "This means we can chortle at the stocks selected for the Index: C'mon!" The reporter then goes on to not-so-gently critique the index's components and suggest a few alternative stocks for the index.

The onus is not exclusively on editors to maintain an objective distance between investments and reportage. When Guinness Flight was setting up a fund from the Wired Index, "it was a pointed rule that Guinness staff not recruit our people to invest in the fund," says Wieners. For example, Guinness is not allowed to leave brochures in the lobby of Wired's office. "We don't want pressure on our editorial staff that way," he says.

Has enough been done by the media companies to ensure objectivity?

The Poynter Institute's Steele is diplomatic. "Some news organizations have very detailed codes that may [have been] created to protect their financial interests," he says, "while others have less specific guidelines." Those that steer clear of the codes sometimes do so out of fear that they may prompt lawsuits stemming from newsgathering and publishing decisions, he says.

While some media companies are well-suited to set up a stock index, others should think twice before getting into the game. The most basic criteria: a recognized expertise in the area that is considered for indexing, and a certain degree of financial savvy among those setting up the index. This is one area where specialization can add to a publication's credentials. For example, if a publication specializes in covering the health care industry, a biotechnology index makes sense. The guidelines for setting up an index are similar to reporting: cover what you know and present it to your audience in an accessible way.

Even when all the pieces of the indexing puzzle fall neatly into place, expect to encounter a fair amount of criticism over both the makeup of the index and how you cover its components, editors warn. "The pitfalls [of creating an index] are that everyone's a critic, and everyone seems to think they know better than we did," says Wieners of Wired. "We spent a lot of time trying to justify our decisions."

Wieners' advice to publications considering establishing an index of their own? "Be as clear as possible in objectives for starting this, and be open to feedback."

Creating and maintaining an index "is a lot more work than it looks like from the outside," says Dow Jones' Prestbo. "But that's not a revelation. Most things are."