Koenig: Know What’s In Your Index

December 05, 2013

Evolution Of Indexing

As indexes have evolved from simple market barometers to benchmarks for measuring the skill of professional investment managers to the direct basis for investment products, it’s more important than ever for investors to know how their index is built and maintained.

The first index strategy was launched in 1971, and the first index-based mutual fund in 1975. After more than four decades, assets in index-based strategies reached more than $7 trillion worldwide in 2013. And in recent years, the exchange-traded fund industry’s rapid growth has led to more than 1,500 U.S.-listed exchange-traded products, with more than $1.6 trillion in assets.

Indexes have also seen significant evolution in how they are constructed and the range of strategies they target. Since the introduction of the first size and style indexes in the early 1980s, investors have been able to more accurately measure specific market segments and more precisely tailor their portfolios based on their investment objectives and risk tolerance.

Recent innovation has led to the development of alternatively weighted indexes—often referred to as “smart beta”—including equal weighting, fundamentally weighted, low volatility, momentum and others. These new indexes offer investors a way to diversify their index-based exposures, complement traditional market-cap-weighted indexes and target specific characteristics or factors.

Here is a simple framework for evaluating index:

  • Representation: What is the market segment covered and how complete is that coverage?
  • Portfolio Fit: How does the index’s market coverage affect the portfolio’s risk/return profile? And how does that fit with the investor’s objectives and risk tolerance?
  • Investability: Are constituents of the index readily available to investors and liquid so that they can be easily bought and sold?
  • Objectivity & Transparency: Is the index constructed using a rules-based, transparent approach, with clear rules that are readily available in a published methodology document? Or is the approach more subjective and opaque?
  • Weighting: How are constituents weighted? By market capitalization, fundamental characteristics or a single factor such as low volatility?
  • Rebalancing: How frequently is the index rebalanced? Annually, quarterly, monthly? And how does that affect index turnover?
  • Ongoing Maintenance: Are IPOs, mergers and other corporate actions added or removed using a disciplined, predictable process?

There are many features of index design that investors need to be aware of when selecting an index as a benchmark or as the basis for an investment product. A few key design choices include: How does the index balance the trade-offs between representativeness and investability? What criteria are used for selecting constituents, and how are those constituents weighted? How frequently is the index rebalanced? Does the index provider use a rules-based approach that is transparent and objective, or are decisions for including or excluding constituents made using an approach that’s subjective and more opaque? Is the index provider established and widely used, with processes that are time-tested—particularly through periods of market stress?

All of these design criteria are just a few areas that can give investors a basis for truly understanding the indexes they rely on every day. It’s important that investors take the time to educate themselves about how the indexes underlying their investments are constructed. Investors need to understand the exposures delivered by an index, how consistent those exposures should be over time and how the index would be expected to behave in various market environments.

Just as financial professionals seek to understand the four P’s of active investment managers, it’s critical to understand the details of how an index is built and maintained to help ensure investors gain their intended exposures and avoid potentially unexpected outcomes.

David A. Koenig, CFA, FRM, is an investment strategist for Russell Investments.



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