Building A Better Country Index

August 21, 2014

BuildingABetterCountryIndex

This article focuses on how one particular subset of indexing—single-country funds based on arguably superior index construction methodology—is changing one element of the international investing landscape. In a way, it’s ironic that innovation is still needed in these most basic building blocks of indexing, but indeed it is. The article reviews the key elements of benchmark design; the unique challenges involved in developing a complete and accurate single-country benchmark; and several examples of the innovation that is taking place in the development of new, single-country benchmarks. While the article focuses mainly on broad benchmarks covering Israel, we also address the issue of building better indexes for foreign markets from the perspective of other countries and sectors. What we hope readers will see is that there is still opportunity for innovation with single-country benchmarks, especially when they are liberated from the constraints of the most prevalent global benchmark frameworks.

‘Perfection Impossible’: Revisiting Key Elements Of Benchmark Design
As noted 12 years ago in this journal,1 and 10 years ago in the book “Active Index Investing,”2 it is exceedingly difficult, if not impossible, to create a perfect index. This is due not only to the different uses of indexes—for example, for benchmarking portfolio performance or for use in asset allocation strategies—but also because of the inherent trade-offs involved in their design.3 While these trade-offs, and how best to minimize their impact, continue to be debated among index professionals, there has emerged general agreement over the best practices for index design and construction. These generally consist of seven key criteria, a review of which follows below.

Perhaps the most important of these seven criteria is completeness, or how effectively the index represents the investable universe for active as well as passive managers. A fully complete index is broad, deep and enhances diversification for investors. Although “completeness” is a seemingly vague term—one that could mean different things to different investors—“complete coverage of the targeted asset class is the foundation for the utility of indexes in all their potential applications.”4

The requirement that an index be investable follows logically from the issue of completeness. An index comprising illiquid securities, those with a small free float or subject to onerous investment restrictions, is of limited utility to investors seeking to use the index as a benchmark or to form the basis of a tracking instrument or fund. Note, though, that the requirement for completeness and the need for investability would seem to be mutually exclusive. We discuss this conundrum when looking at the trade-offs involved in creating the best possible index.

A quality index also needs to be transparent. It must have clear rules for the way the index is created and managed, and these rules, or methodology, must be publicly available to all interested parties. It is especially crucial for investors to be aware of the rules surrounding index rebalancing, including the inclusion of new constituents and exclusion of existing constituents. Similarly, index return and constituent data must be readily available and accurately priced on a timely basis. Investors must be able to easily access total and net return data and information on dividends. All data must be released in a timely and efficient manner.

In a classic “chicken and egg” manner, the better an index meets the above criteria, the more widely accepted it will be among investors. And the more accepted by investors, the more widespread its use will be, both for benchmarking and to serve as the underlying basis for investment products.

On a more technical level, an index will find greater acceptance by investors, particularly large institutional investors, if it offers the easy ability to cross buy and sell orders. This allows institutional managers to match orders without added transactions costs. Equally important is the availability of listed or OTC futures and options, which provide investors with additional tools for managing risk and exposure levels. Finally, the ideal index meets all of the above criteria while also minimizing constituent turnover and transaction costs associated with rebalancing.

 

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