III. The Seven Key Criteria of a good index
Indexes are useful as benchmarks for active management, as the basis for index funds, and as proxies for asset classes in asset allocation. Ideally, one should choose an index that can be used for all three purposes simultaneously, as added fungibility makes the utility of the benchmark that much greater. When selecting indexes to use for one or more of these purposes, one must consider all of their characteristics and determine which indexes best fit the investor's needs. Still, no equity index is perfect, as tradeoffs are involved, and these are discussed in Section IV.
How should one choose from among the competing alternatives? In addition to market-capitalization weighting, which is a prerequisite of a good index and is common to all indexes covered here, there are seven key criteria that are useful in identifying a good broad-capitalization equity benchmark. Obviously there are many more minor criteria, but we find it useful to categorize the major criteria in 7 broad groupings. These criteria formed the basis of the "Benchmarks 101" article published in the Journal of Indexes in the second quarter of 2001 as well as earlier essays published by BGI. Please visit www.indexuniverse.com/JOI to read the Q2 '01 article, as well as a list of additional criteria, under the heading of "Don't Stop at Seven."
The Seven Key Criteria of a Good Broad-Capitalization Index
Does the index accurately reflect the overall investment opportunity set, both in terms of market cap-range/country coverage and company inclusion? The more complete an index - the broader and deeper its coverage - the more effectively it represents the investable universe for both active and index managers. By spreading its allocation among most of the available securities and markets, a comprehensive index maximizes diversification. Completeness is probably the most important of the 7 key criteria, as complete coverage of the targeted asset class is the foundation for the utility of indexes in all of their potential applications.
Does the index include only those securities that can be effectively purchased by investors? For non-U.S. benchmarks, does the index screen out shares and market segments that are restricted for foreign investors? Obviously the goal of investability stands in juxtoposition with the objective of completeness, and the tradeoff between the two often requires a user to make an explicit preference decision.
3. Clear, published rules and open governance structure
How transparent are the rules that govern the benchmark? Are these rules well-established and publicly available? Such rules provide predictability to both portfolio managers and asset owners, and make it easier to anticipate how changing market conditions will be reflected in the benchmark. For an index to be truly useful to the various users of benchmarks, index construction rules should be fully transparent, especially during index reconstitution periods and during major corporate actions.
4. Accurate and complete data
For an index to be useful, return and constituent data must be accurate, complete and readily available. Investors should have access to at least the following information: price/total/net dividend returns, consistent sub-indexes, quality and timely release of data, transparent release of index changes, and historical returns. While some believe that the ready availability of index data somehow hurts investors in index-based products, I believe the opposite is true. The more understanding of the methodology and constitutents of an index, the more comfort investors have in products based on the index.
5. Acceptance by investors
In general, investors prefer an index that is well known and widely used. This gives an investor faith in the ongoing integrity of the index, since it will be under scrutiny from a variety of market participants. Furthermore, wide use enables effective peer group comparison. The performance of non-standard indexes and index products are invariably compared to the standard benchmark, Academic and proprietary research, the basis for asset allocation studies, tends to focus on established benchmarks to provide relevant insights for investors, Finally, without broad acceptance of an index, there might be inadequate availability of supporting investment products based on the benchmarks (including active funds and derivative products).
6. Availability of crossing opportunities, derivatives, and other tradeable products
Indexes that are widely used, especially within pooled investment vehicles, offer potential cost savings because they provide crossing opportunities within the fund complexes of large institutional investment managers. Crossing allows an institutional investment manager to equitably match buy and sell orders without the typical costs that would be incurred in the open market. Such indexes also generally create a more liquid/cheaper to trade OTC derivatives market, particularly in total-return swaps. The availability of listed futures/options on some major benchmarks, and the proliferation of ETFs on virtually all major benchmarks/asset classes, further benefits asset owners and portfolio managers who use these accepted benchmarks. Ideally, a widely-used benchmark fosters a virtuous circle of activity by a critical mass of investors, in turn creating the potential for crossing trades/activity. Broad acceptance of a benchmark creates a "network effect" between fund managers, sell-side brokers and the cash and derivative markets that reduces transaction costs for movement in and out of index portfolios.
7. Relatively low turnover and related transaction costs
All indexes incur a certain amount of turnover as they maintain index constituents in line with their stated methodology. In general, the lower the turnover, the fewer rebalancing costs are incurred, and the easier the index is to track. By design, a broader benchmark favors lower turnover, while an index that works within a narrowly defined market segment has greater turnover and transaction-related costs. Furthermore, and index with a pre-defined number of stocks (e.g. S&P 500, Russell 2000, S&P Latin American 40, etc.) will have some degree of additional turnover to maintain the fixed number of constituents.