Considerations for choosing an index
In evaluating the appropriateness of an index, investors should take a holistic approach and explore, for example, how well the index strategy suits their objectives, risk constraints, and beliefs as well as how well it complements or interacts with the allocations designated across the rest of the portfolio. The index attributes you should consider can also depend on how the index will be used.
Indexes as benchmarks: Why index selection matters
|Comprehensive representation of the intended market or market segment||When utilizing indexes to define the mix of asset classes appropriate for a plan or investment portfolio, it is important that each index deliver accurate and comprehensive representation of its intended market segment. Omitting eligible securities from an index can lead to unintended consequences such as errors in the asset allocation structure of the total portfolio.
Complete market coverage is also important when using an index to benchmark an actively managed investment. Comprehensive coverage of the entire investable opportunity set provides an appropriate basis from which to accurately distinguish alpha from beta. In other words, measuring the success of an actively managed investment using an index that fails to offer complete coverage of the assigned asset class can result in an unfair evaluation of manager performance.
|Transparent and objective index construction||A transparent and objective approach to index constituent selection provides a more accurate, unbiased representation of the market it is designed to measure rather than a subjective, committee-based method. Objective rules allow investors to understand and potentially anticipate why and when changes are made to the index.
Subjective, committee-driven membership selection can result in delayed inclusion of newly available opportunities that can impact an index’s representativeness. If the index is not truly representative, it can not be used to define appropriate asset allocation, nor can it be trusted as an effective means of gauging investment performance as compared to the overall market or market segment.
|Regularly rebalanced and maintained||Regularly scheduled rebalances and clearly stated maintenance rules to adjust for more frequent changes such as those due to corporate actions like spin-offs and IPOs ensure that the indexes are always aligned with market conditions. This allows for accurate and up-to-date measurements of the markets and market segments.|
|Modular structure with no gaps or overlaps||Index families designed to represent broad markets as well as more granular market segments should be modular in design. Modular indexes can be use as building blocks, offering a precise picture of the market and its segments. This enables accurate asset allocation implementation without unintended over-/under-allocations to small, mid or large cap asset classes.
An investor allocating specific portions of their portfolio to large and small cap, for example, should be able to rely on indexes to clearly differentiate between these market segments with no gaps or overlaps. If the market cap coverage ranges of the large and small cap indexes overlap significantly, the investor could experience unintended overexposure to the mid cap market segment, undermining their intended allocations to large and small cap.
Indexes as the basis for index-tracking investment products: Why index selection matters
|Representative||Since the goal is to gain access to a particular market or market segment, the index should aim to be as representative of this market segment as possible.|
|Cost efficient||Transaction costs are incurred by passively managed investments when changes to the underlying index constituents and weights are made. It is important that the index balances its goal of being representative with the need to keep turnover costs manageable.|
|Objective and transparent||Because the investment is replicating the index, it is important that the rules that govern the index design and calculation are published openly and transparently. The investor should be able to understand and anticipate changes to the index. If not, replicating the index can be difficult and unintended tracking errors may occur.|
|Investable||The index should limit its holdings to those readily available to the investor. For example, index weights should be calculated using float-adjusted market cap, meaning the index should only include the shares that are freely available for purchase by the average investor rather than those held by employees or other investors who are restricted from selling their shares. If shares not available to public investors are included in the index, replicating the index can be difficult, and the demand for shares from investment funds replicating the index can actually cause unnatural stock price spikes.|
Why index governance is important
It is important for an index provider to have a formal governance system in place to proactively evaluate their indexes to ensure they are responding and adapting to the evolving market. Meanwhile, consideration must also be given to the fact that frequent implementation of index methodology enhancements can be burdensome to the end user. The index governance process must weigh the pros and cons when contemplating changes that may have downstream impact on index users. Methodology changes and other index enhancements should be reviewed, considered, and approved within a well-defined governance framework that draws from internal expertise as well as external independent committees of leading market participants.