Koenig: Know What’s In Your Index

December 05, 2013

Knowing what’s under the hood has never been so important.

An index is an index, right?

Clearly, that’s not correct. Indexes are not all created equally. And no two indexes are alike. Indexes that target the same objective or asset class can take very different construction approaches. And these differences in methodology can lead to very different exposures and performance characteristics.

In evaluating and selecting investment managers for client portfolios, financial professionals typically conduct significant due diligence into a manager’s philosophy, process, people and performance—commonly known as the four P’s.

When it comes to index-based strategies, however, investors sometimes spend time examining the characteristics of the end investment product, but might put less rigor into understanding how the underlying index is constructed. Although it is of course critical to have clear insight into the end investment product, it’s equally important to understand how the index is built.

Simply knowing that the investment product is a small-cap value fund or a low-volatility fund is not enough. But where can investors look for education about their indexes? With thousands of indexes in the marketplace, it can sometimes be challenging to know exactly where to find the best information. Investors have numerous resources accessible to them and should look to the index methodology document on the index provider’s website, the fund prospectus, fact sheets and other materials.

Here are some tips for educating yourself on indexes:

  • Index methodology document: Index providers typically publish detailed methodology documents on their websites.
  • Fact sheets and other materials: Most index provider and fund provider websites also include fact sheets, research papers and other materials that include overviews of index construction, historical performance, fundamental characteristics and other information.
  • Fund prospectus: All fund providers’ websites include a fund’s prospectus with information about the benchmark. Taking a few minutes to read the prospectus is an important step in understanding the index and the fund.
  • Webinars: Index providers and others offer educational webinars that provide insight into index construction and how index-based investments can fit into an investor’s portfolio.
  • Independent research: IndexUniverse, Morningstar and others publish a wide body of materials about indexes and hold conferences and other educational events where investors can gather information and have the opportunity to ask questions.
  • Telephone: Don’t forget that index and fund providers are only a phone call away and welcome the opportunity to answer any of your questions.

 

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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