Indexes are often praised as being fully transparent and rules-based, with published rule books spanning hundreds of pages. Within those rule books, many smaller details can also have a significant influence on the performance of a benchmark and its characteristics. In this article, we highlight three areas that can easily be overlooked, but which may be of interest for investors seeking a specific exposure or wanting to invest in a derivative product based on such an index. We look at the treatment of corporate actions, interest rates and country exposures to illustrate why it is necessary to consult and study index rule books and compositions with great care in order to fully understand their effects on the investment.
The Treatment Of Corporate Actions
When looking at an index, investors often focus on its selection methodology (i.e., which components are in the index) and its weighting scheme (i.e., which component or components influence the index most, and to what extent). From the perspective of these two dimensions only, the majority of indexes, and certainly most major market benchmarks, are actually quite simple. Selecting the largest and most liquid stocks from a country, region or market segment and weighting them by their size does not hold any major surprises. However, even for "plain vanilla" indexes, the calculation of the index often involves additional complexities that may be overlooked by those evaluating an index's methodology. This is especially true in the area of the treatment of corporate actions. In other words, the rules governing how capital raisings and other corporate events are reflected in an index can have a significant impact on its behavior and performance.
To illustrate this, below we examine different types of corporate events and their treatment in indexes.
Regular dividends are a relatively simple event. The holder of the index portfolio receives a dividend payment. In price indexes, this leads to a drop in the index value. In total-return indexes, this price drop is adjusted for in the index calculation. So far, so simple; however, there are three different ways in which this reinvestment can be calculated:
Option 1: Reinvestment in the Index Portfolio – In this case, the received cash is redistributed across all components of the index. This means that an investor tracking the index will need to purchase additional shares in all components of the index according to their current weighting, up to a total amount equal to the dividend payment. This method has the advantage that the portfolio represents the true market capitalization weightings of the underlying market correctly at all times. On the downside, this adjustment generates relatively large amounts of trading activity and therefore costs, as a trade needs to be made in all the components of the index.
Most international index benchmarks, including indexes from Stoxx, MSCI and FTSE, follow this methodology.
Option 2: Reinvestment in the Single Stock – In this case, the cash received is reinvested only into the stock paying the dividend. An investor tracking the index would therefore purchase shares of that stock for the amount of the payment received. This artificially increases the market capitalization of the affected stock to a synthetic level, equivalent to that observed prior to the payment. Reinvestment into the entire portfolio still happens, but not until the next regular rebalancing of the index. This method reduces portfolio adjustment costs, as transactions only take place in one share in the portfolio.