Index Committee Or Index Rules?

April 26, 2012

For their primary use as the basis for passive investment strategies and investment products such as futures and options, ETFs or certificates, one of the key aspects that investors look for in indices is exactly this passive nature. A passive, index-tracking approach has been shown to provide superior returns over the average returns of actively managed strategies, according to multiple academic studies of mutual fund returns. Fully rules-based indices comply with this value proposition as they will always duly execute the published and transparent index rules, and are hence by definition fully passive.

By contrast, a committee with direct influence on the composition of the index brings a judgemental or active component to the way the portfolio is constructed. In order to understand this, it is worth examining the types of decisions that an index committee usually faces. As stated above, in most cases the objective of the index is pretty clear (for example, to capture the largest or most influential companies in a given market). A committee might therefore need to override this implicit algorithmic choice of companies.

Rules-Based And Committee-Based Index Component Selection
For a larger view, please click on the image above.

So Why Would This Be Necessary?

The first argument for this is index continuity, or the aim to make as little change to the index portfolio as possible: in other words, to avoid "unnecessary" turnover. This might entail a company being allowed an extended stay in the index in the event it breaches the relevant thresholds, under the assumption that the company may bounce back by the next index review. Rules-based indices do and need to allow for extra continuity by introducing special buffer rules—which define how much "goodwill" should be assigned to any company on the threshold of index exclusion or inclusion. The judicious setting of these rules, in order to ensure index continuity, is one of the key functions of the rule-setting committee.

In committee-driven indices the decision on index inclusion or exclusion remains with the committee, which effectively takes an active decision on how long to stick with a specific company that has dropped out of the original scope of the index. This leaves significant elements of uncertainty over the future index composition. In turn, the index composition plays a major role in determining the pricing and risks of long-term derivatives contracts, for example, dividend points swaps and futures.


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