What Is An Index: A Brief Guide

Over the past two decades, investible indices have grown exponentially, capitalizing on the popularity of passive investing with its ease of access, performance and low fees. There are now over three million indices with more than $8 trillion invested in ETFs and this excludes pension funds directly investing in indices. In this guide, we will examine the key mechanics of an index, including the rules, selection criteria, weighting and rebalancing.

What Is An Investible Index?

An index is a rules-based, usually passively run process that tracks the change in value of a group of assets. It measures the sum of the changes as each individual component changes according to their weight. In the investment universe, a benchmark index is a broad index that seeks to be representative of a country, region or market segment. Some well-known examples include the Bloomberg Barclays Aggregate Index, Euro Stoxx 50, Nasdaq 100, MSCI World, S&P 500, Russell 1000 and Wilshire 5000. Benchmark indices are mostly market capitalization weighted, whereby the largest assets have the most weight.

Non-benchmark indices are investible indices that may include single or multiple asset classes from equity and fixed income to commodities and REITs. Some indices track investment factors, such as value and momentum and are known as factor (or smart beta) indices.

Index Rules

Every index has a set of rules which reflects the criteria required to meet the objectives of the index. These rules are predefined and usually non-discretionary with changes kept to a minimum. This is an important feature that differentiates indices from active management. By having preset criteria, indices are able to consistently track their stated objectives without deviation.

Indices are not static and the rules do evolve to take into account changes in the market structure, underlyings, issuance and liquidity. For example, the constituents of the S&P 500 Index changed at least eight times between January 1, 2015 and April 30, 2018, and its methodologies was modified 22 times within that period.¹

Some indices may have committees to provide oversight and guidance. The S&P 500 has an index committee overseeing stock selections and other changes to the index to ensure that it remains representative of the large-cap market in the US.²

The rules of each index consist of three major components: selection criteria, weighting and rebalancing.

Selection Criteria

Creating an index is like a filtering process - the index provider can keep on adding filters until they get to their desired market segment. Some of the most common filters include region, country, sector or industry; for example, the Russell 1000 Index tracks the performance of the largest 1000 equity stocks in the United States.

Factor indices are more involved. They are typically a subset of a benchmark index but aim to track stocks or other assets that display certain “factors” such as value, momentum or quality. The filters used to create a US equity quality index may look like the followings:

Filter 1 - Geography: the stocks must be US-based companies.

Filter 2 - Market Capitalization/Liquidity: large and liquid stocks will ensure the ease of trading (small-cap stocks may have large bid/offers and low volume; and having a large position could move the price). The typical market capitalization filter for a large-cap index, for example, is $1 billion or higher. A common equity liquidity threshold is to have an average daily trading volume of greater than $20 million per day.

Note: In some cases, the index provide could elect to start the process from a pre-existing universe, such as the MSCI USA Investible Market Index, and negate the need for steps 1 and 2.

Filter 3 - Quality Attributes: the metrics at this step vary from one index provider to another and there are no common standards. For an equity factor index, the metrics may include some combination of profitability, earnings stability, return on equity, etc. Note that for a fixed income factor index, the quality metrics may switch to credit ratings, duration, etc.

What constitutes “quality” can be a subjective interpretation and index providers have complete freedom over the choice of metrics. This is where the performance of different indices diverge and investors should pay attention to the metrics used by each provider.

Read our guide on Factor Indices.

Weighting Scheme

Similar to the filters, index providers also have the freedom to choose a weighting scheme that they deem appropriate for their indices. The most common methodology is market capitalization which allows for a very large capacity. This can be inefficient though - for example, to profit investors need the largest stocks to continue growing fast, but it is usually smaller stocks that grow faster.

Modified market capitalization weighting partially addresses this flaw by imposing a cap on the largest weights. The simplest scheme is equal weighting but that could cause a different set of issues such as a limitation on capacity. Factor indices may weight the stocks by their factor strength; other indices could also weight by risk or many other possibilities.

Read our guide on Index Weighting Schemes.

Rebalancing and Reweighting

These are two important rules of indices. Rebalancing is when new constituents are selected based on the preset criteria of the index. Reweighting is the process to return constituents of an index to pre-set weights. As prices move, weights drift. Some stocks or bonds appreciate and thus have a higher effective weight in the index; and vice versa. Reweighting will bring them back to the preset weights by selling portions of the winners and purchasing additional portions of the losers.

An index can rebalance and reweight separately or at the same time. In most cases it makes sense to do them together to reduce trading costs. (Indices can even rebalance daily, but the transaction costs could be substantial and potentially wipe out any gains to investors).

Benchmark indices tend to do rebalance and reweight quarterly or biannually. Many factor indices do it monthly or quarterly, as they need to re-run their selection metrics in order to maintain a constant exposure to the style that they are tracking. For instance, a key metric for a momentum index is stock price movements and current news that may affect them, so the index provider may opt to rebalance the index every month to maintain exposure to momentum stocks. Meanwhile, factor indices that apply accounting information such as earnings fundamentals to their selection criteria, such as quality indices, are more likely to rebalance every three months after companies release their quarterly results to the market.

Other Important Index Elements:

Backtesting

Index providers make decisions on the selection criteria, weighting, rebalancing and reweighting based on a process called backtesting. It is a long, highly complex process during which the index providers will run through numerous scenarios and tests in order to find the optimal parameters for the index.

Good backtests sell indices, and sometimes that may lead to over-engineering,  effectively optimizing to the past, obscuring the fact that the index is unlikely to repeat that performance in the future. At The Index Standard, we prefer indices using academically proven criteria and simple parameters.

Fees

The majority of benchmark indices and indices used in ETFs do not contain fees at the index level, but some do and investors should be aware of it. Other types of fees may be included but hidden, such as a bid offer spread that may impact investors. Consider a liquid fixed income instrument that trades at a mid-price of 100, with a bid of 99 and an offer of 101. If the index rules state that the index can purchase the bond at the bid price of 99 and not the mid-price at 100, the investor will effectively pay an extra $1 to enter the position. This in an extreme example but situations like this do occur.

Conclusion

The rules-based approach of index investing which avoids personal judgement and expenses as seen in active management is a big plus for investors. However, the manner in which index providers set the rules for their products does have a substantial impact on index performance and, ultimately, returns. Investors should pay attention to the index “recipe” and understand the differences before making any decisions.

The Index Standard apply more than 30 metrics when rating each index or ETF to help guide investors through this process. Visit The Index Standard Ratings for more information.

 

References

1. Passive in Name Only: Delegated Management and Index Investing, Prof. Adriana Robertson, University of Toronto, 2019
2. S&P: Inside the S&P 500: An Active Committee, David Blitzer, 8/14/2014