One of the key arguments for investing in indices is often cited as transparency of the index rules. But how transparent are these rules in practice and how reliable is their application? In this article, we will examine the management practices for two groups of indices: a group of the widely used blue-chip indices and the newer area of sustainability (or ESG) indices.
While indices depend upon a number of rules to function, all of which are generally associated with the promotion of transparency, this article will focus only on those rules which determine the composition of the respective indices, as well as those handling the treatment of major corporate actions affecting the index composition. Similar arguments can, however, be made for all other aspects of the index calculation as well, even though the effects may be less visible to the general investor.
A LOOK AT MAJOR BLUE-CHIP INDICES
First, we will look at the major blue-chip indices. All of these indices share the attribute that they claim to represent the largest or most important stocks in a specific country or market. It is hence often the common perception that these indices automatically contain the largest companies by market capitalisation. In practice, however, these rules are often more complicated and actually significantly less rules-based than the initial perception suggests.
It is common practice for indices to be governed or advised by an index committee, made up of indexing and market experts. However, the role of these committees in determining the index composition varies extensively from one index firm to another. Broadly speaking, index committees' influence on blue-chip indices can be divided into two categories.
First, rules-based indices use a set of quantitative algorithms to determine the index composition at pre-defined intervals, or in response to corporate actions. In this case, index committees take a secondary role, with any changes to index rules taking effect at future points in time. The committee does not decide per se on the actual composition of the index, focusing merely on future rule changes. The committee may, however, also intervene in a short-term manner in cases where the potential harm to index investors from a strict application of index rules might outweigh the benefits of predictability. One example would be the exceptional spike in the stock price of Volkswagen AG, a member of the DAX index, in 2008.
Volkswagen shares briefly hit prices of over €1,000 per share—making the German car manufacturer the largest publicly traded company in the world. The resulting increase in the weight of the shares in the DAX index to over 25% vastly exceeded European regulatory mutual fund diversification requirements, as set out in the UCITS directive, and the DAX index committee advised to take immediate measures to cap the weighting of the component to a compliant level. The index provider also acknowledged that an update of the index rules was required and this was duly executed shortly afterwards by introducing a set of rules to create a transparent basis for dealing with similar cases in the future. It is this continuous improvement of index rules that ensures an overall minimal level of interference in rules-based indices.
This type of committee will be referred to as "rule-setting committee" going forward. Well known examples for fully rules-based indices are Germany's DAX, the leading European equity benchmark, the EURO STOXX 50, or the UK's FTSE 100.
By contrast, in committee-driven indices the committee takes a significantly more active role. The index rulebook usually defines a framework or principles for decision-making. The rulebook does not, however, prescribe index changes based on quantitative measures. Instead, changes are determined by the decision of the committee, according to the defined guiding principles. The committee—which we will refer to as the "committee" or "index committee" going forward in this article—may also review the principles during their meetings. Among major indices in this group are the US equity benchmarks S&P 500 and the Dow Jones Industrial Average.
It's clear that indices from both categories have enjoyed considerable success, and good arguments can be made for either method. Below, we contrast the two methods and outline the advantages and disadvantages of each.