Sebastian Cheek reports on how indices are built in order to contend with the varying market conditions and the challenges looking forward
There has been a trend in the indices field over the past 10 years or so to move away from indices that deal purely in traditional asset classes, such as equities, towards alternative asset classes. Now there is an index for almost every conceivable asset class, from commodities and all its sub-divisions through to infrastructure and real estate. Look hard enough and you can even find indices for more esoteric investment areas such as wine and art, especially as investors have sought to tailor indices to better suit their investment needs.
Thomson Reuters is the latest company to enter this expanding arena. The media group recently launched a range of 800 branded indices following an increase in demand from clients and markets. The indices will cover some 44 countries, 18 regions and 10 business sectors.
There is a considerable amount of work going into liquidity analysis and it is at this first hurdle you find out if an index is usable or not
In today’s marketplace indices occupy three key roles: Firstly, as a tool to benchmark investments and measure performance; secondly, as a basis for products, such as exchange traded funds (ETFs); and thirdly, in a research and asset allocation capacity for investors using indices to investigate historic performance.
Pension funds tend to stick to the first use where they issue mandates to their managers to manage an asset class then use an index to measure the performance.
When it comes to creating a new index it is important to be able to access the underlying market so that the securities can be traded freely. It also needs to be transparent so the names and weights of securities comprising a benchmark should be clearly defined and open to international investment.
Historically, indices were constructed to represent a particular market, but often this did not take into account the fact that some shares were not available. The advent of ‘free float’ came into being around 10 years ago where the level of a company’s publicly available stock is analysed. Indices are now free float adjusted to give a better indication of what can actually be bought in the market.
There are, however, still some indices around the world where you cannot buy domestic stocks. In Saudi Arabia, for example, only investors from the countries of the Gulf Co-operation Council can freely trade shares on the Tadawul index, although the exchange has been moving steadily to slacken this. Last year, the Saudi Capital Markets Authority (CMA) allowed foreign investors to trade shares by entering into swap agreements with ‘authorised persons’ in the kingdom.
“The market cap of Saudi Arabia is one of the largest around but no international investor can buy Saudi stock directly,” said S&P Index and Portfolio Services senior director John Davies. “You need to consider whether you can physically get access to underlying securities.”
MSCI Barra executive director and head of EMEA applied research, Dimitris Melas explained MSCI ensures the securities included in its indices are reasonably liquid and tradable. “We use measures to screen out securities that may be very illiquid or have a small percentage of shares actively traded (low free float),” said Melas.
There are also regulatory factors that drive the creation of new indices such as the UCITS 5/10/40 regulation, where certain types of mutual funds can not invest more than 10% of the portfolio in a single security and all the securities above 5% weight in the portfolio cannot be in aggregate more than 40%.
“In highly concentrated markets if you use market cap weight you might find that there are some index constituents that are more than 10% of the index, so in response to this we have developed a series of 10/40 indices,” said Melas.
Typically pension plans use established benchmarks to measure performance but as FTSE executive director of global sales Imogen Dillon Hatcher said, indices can be customised for a number of different clients, from exchange traded fund (ETF) providers through to hedge funds.
In these cases the index provider calculates indices and develops them how the client wishes but they never go out to the general public and do not carry the index provider’s brand. Instead the index would say ‘as calculated by x’.
It is beneficial to have the branding behind an index because when index values are put forward there could be some dispute with clients about what this value should be. If an established index provider calculates it the rules and regulations are out there so there is no argument about what that number is and risk is subsequently mitigated.
MSCI’s Melas explained: “With our standard indices we are fully responsible for the methodology and before we make changes we do public consultations. The custom indices are built according to the needs of a particular client and the methodology is dictated by the client. These indices are calculated by MSCI but are customised for a particular client.”
Dillon Hatcher added the secret to creating indices is getting in tune with clients. “It is about being able to sit opposite someone working in a fund management operation or an investment bank and fully understand what rocks their world and makes a difference to their decision making capability.”
According to Dillon Hatcher the body representing Australia’s superannuation industry in Australia asked FTSE to create a tax adjusted index series based on the specificities of the Australian tax system. “We have thrown several teams at that for a number of months and have seen pleasing take up from the super funds and the fund management industry.”
Advantages of index investing
All main series indices are highly transparent because rules are always published and in most cases the indices are governed by committees of independent practitioners. Also, index products are a low cost vehicle so the fees investors pay are relatively low compared to active management.
Last month S&P’s Index Services released the mid-year 2009 results for its Standard&Poor’s Index Versus Active Fund Scorecard (SPIVA). For the five-year period ending June 30, 2009, it showed that the S&P500 outperformed 62.9% of actively managed large cap funds, the S&PMidCap 400 outperformed 73.4% of mid cap funds, and the S&PSmallCap 600 outperformed 57.4% of small cap funds.
However, S&P also pointed out that asset weighted averages suggest a more level playing field, with active managers level or ahead of benchmarks in most categories except mid-caps and emerging markets.
S&P’s Davies commented: “A large number of active funds do not beat the benchmark so you could argue that if you are paying an active fee and your manager is not beating the benchmark then why not buy an index-linked product.”
Exchange traded funds
One index tracking product that is really flying at the moment is ETFs, which have thrown up good opportunities to commercialise a lot of indices.
S&P’s Davies observed the first ETF was launched 16 years ago on the S&P500. “In Europe, however, they have been around for eight years,” he said. “Historically, pension funds in the US have been avid users and only now it is really taking off in Europe.”
In many instances ETFs are the preferred index tracking vehicle over certificates, swaps and other structured products because they alleviate counterparty exposure. They are also highly liquid as they can be bought any time of the day and because active managers do not consistently hit their benchmarks, ETFs are also increasingly being preferred over traditional mutual funds.
iShares head of product development EMEA Axel Lomholt reiterated the liquidity advantage. “The fundamental driver is liquidity because an investor wants to be able to go in and out on a daily basis,” he said. “There is a considerable amount of work going into liquidity analysis and it is at this first hurdle you find out if an index is usable or not.”
BGI global head of ETF research and implementation strategy Deborah Fuhr said ETFs are being launched on new indices all the time. “There are still around 900 in the pipeline of people wanting to launch,” she said.
“People select products based on the index first followed by other criteria, so the index is a key determinant in people selecting an ETF, because they would want exposure to the MSCI Emerging Market index, for example.”
Over the last 10 years, changes in accounting practices and a downturn in markets has led to increasing scheme deficits and piled pressure on funds to recapture losses through traditional methods or new areas of investment. As a consequence there has been a move towards more passive investing and global thematics, for example clean energy, water, and renewable energy.
“We work with clients to build indices along these themes,” said Davies. “There is also a renewed interest in ethical investing and corporate governance.”
Melas added: “One trend seen recently is one towards global investing rather than trying to invest regionally or on a country basis. We have seen increasing demand for more comprehensive coverage of the opportunity set in international equity markets – in response we evolve our own methodology and how we construct indices.”
According to Dillon Hatcher there has been a shift away from standard market cap based indices – where indexing started – towards the investment strategies wrapped up in an index. Thus a blurring of the lines between active and passive investment has occurred.
“The debate has raged about if this is true indexation and if we are heading into the active space,” she said. “There has been a real rise in the non market cap weighted investment strategy type ideas and you will see over the next few months more of these ideas coming forward.”
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