Requirements For Standard And New Forms Of Indexes

February 19, 2013


Standard cap-weighted market indexes have traditionally been used as a reference for determining how much additional risk one is willing to tolerate, in terms of deviating from peer group behavior. This presupposes a basis to consider any index or method as a universally applicable and neutral starting point, but there is ample empirical evidence and theoretical support that this attribution of neutrality is unwarranted and that standard indexes suffer from poor risk/return properties (see, e.g., Amenc, Goltz, Martellini and Retkowsky [2011] for a review of the various drawbacks of cap-weighted indexes).1

More recently, index providers have been expanding their offerings to an array of different types of indexes, while the proliferation of ETFs has given a broader range of investors’ direct access to indexing. A clear trend has been emerging in recent years and reflects a movement away from standard indexes towards constructing indexes with the purpose of fulfilling a specific set of investment objectives, such as obtaining low risk, high risk-adjusted returns, or calibrated exposure to a given risk factor. While most traditional indexes can be clearly seen as “market indexes” that provide a representation of the average performance of investors in a given market segment, many recent indexes can be seen as “strategy indexes” that aim at achieving a given risk/return objective through a set of systematic rules.

As illustrated in Figure 1, there have been numerous index launches in the past few years, many of which involved collaborations of index providers with asset management firms or other third parties.

Due to such heavy index launch activity over recent years, investors are now faced with an increasing variety of index offerings with different construction methods, often from the same provider. In particular, rather than sticking to the default index construction scheme where stocks within a geographic or industry segment are selected by their market cap and then weighted in proportion to their market cap, new index launches often draw on alternative constituent selection schemes and/or alternative weighting schemes. Such innovation naturally raises the question of what desirable properties an index should have in the first place. Also, in view of this increasing variety of index supply, another relevant question is whether investors who make up the potential demand side accept such new index construction schemes and how they integrate the corresponding products into their overall investment process. In fact, while recent innovation and the continuous extension of strategies that are offered from index providers have led to informal debate on where the limits are of what one could reasonably refer to as “an index,” little evidence is available on where index investors actually draw this line. This article focuses on results of the aforementioned survey that provide insights into this question.

To better gauge the attitudes of investment professionals with respect to such innovation and to help anticipate the direction indexing is likely to go in the future, EDHEC-Risk Institute has conducted a survey of investment management professionals in North America. A broad and comprehensive set of questions was asked to allow us to present a clear picture of which attributes of indexes users value. The EDHEC survey consisted of a questionnaire given in Q1 and Q2 2011 and answered by 139 North American investment professionals,4 most of whom are institutional investors or asset managers; further, the overwhelming majority of all respondents have used indexes as investments. This survey was done in parallel with similar surveys conducted in Asia and Europe, to help provide a comprehensive global picture of the indexing industry and note any regional disparities (see Amenc, Goltz, Mukai, Narasimhan and Tang [2012] and Amenc, Goltz and Tang [2011]. This article provides a summary of key results of the American survey concerning investors’ quality requirements for indexes in general and their use of alternative index strategies. We discuss results for equity indexes as well as fixed-income indexes. An analysis of the complete results of the survey is presented in Amenc, Goltz, Tang and Vaidyanathan [2012].

We first discuss survey results on the current use and satisfaction with indexes in equity and fixed-income investing. We then focus on investors’ views on what the fundamental quality requirements for indexes are before providing an overview of respondents’ views on alternative weighting schemes.


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