A Short Guide to Index Selection

UBS

Economic

Summary:

A multi-step process requiring both quantitative and qualitative inputs.

Exhibit 1: Benchmark and index provider selection

Multi-step iterative process comprising quantitative and qualitative analysis

Benchmark selection

It is estimated that more than three million indexes are calculated daily by the major index providers. With such multitude of indexes available, a methodical and objective approach to benchmark selection is helpful in selecting a suitable benchmark for an index portfolio.

The index equity investable universe could broadly be viewed alongside three dimensions: market, size, and strategy, shown in Exhibit. As a first step in selecting an index, investors would need to decide in which of these three dimensions their benchmark should fit.

Market: investable markets are organised in three geographical groups (developed, emerging, frontier) and each group comprises a number of countries.

Decision points:

Developed or emerging, and if exposure to both is required, a combined all-world index or separate developed and emerging.Regional (e.g., Europe, APAC) or country (e.g., US, UK) indexes.If initial exposure would be required to one market/region, would exposure to other markets be required in the future: this would be a determining factor for index provider selection as different index providers classify some of the markets differently (e.g., Korea is classified as emerging by MSCI and as developed by FTSE Russell).

Size: investable markets are organised in three size segments (large cap, mid cap, small cap), with large and mid-cap typically combined in what is known as ‘standard index’.

Decision points:

Large and mid or small cap exposure, and if exposure to all there is required, a combined all-cap index or separate standard and small cap index.

Strategy: relates to the stock selection and/or stock weighting methodology of an index. Some of the key strategies include: market capitalisation weighted, risk premia factors, sustainable factors, thematic, diversified (e.g., equal weighted or a more complex approach to diversification). Other strategy indexes include: currency hedged, derivative (leverage, inverse, protected), and active strategies embedded in an index.

Exhibit 2: The investable equity index universe

After a decision regarding the relevant components of the investable universe is made, investors would typically consider a number of points related to the index construction, including:

Index delivering on its objective: this might sound obvious, but there are cases of indexes being marketed by the index providers with a particular objective, yet upon analysing the data it is evident that the index does not actually meet such objective. For example, if an index claims to be ‘low volatility’, analysis of the historical volatility of returns should provide an indication of how this compares to the volatility of the underlying market cap weighted index.

Simplicity and transparency: one of the attractions of index investing is that indexes are typically constructed via clear unambiguous rules. If the construction methodology for an index is obscure, this could leave room for interpretation of the rules, and could potentially impact the tracking accuracy of the index portfolio.

Rebalancing frequency and turnover: another attraction of index investing is lower cost compared to active management. Indexes with more frequent rebalancing and/or higher turnover would lead to higher transaction costs associated with the rebalancing trades.

Capacity and liquidity: market cap weighted indexes with large- and mid-cap developed markets equity exposure tend to be highly liquid with high capacity, while some non-market cap weighted indexes and/or indexes with emerging markets and small-cap equity exposure could have lower liquidity and lower capacity. This point is particularly relevant for larger mandates.

Breadth: this point relates to the market and size dimensions of the investable universe outlined above.

Risk models (proprietary vs. industry-wide adopted): more complex indexes involving optimisation/tilts are typically constructed using a risk model. Indexes constructed with an industry-wide adopted risk model (e.g., Barra, Axioma, etc.) allow their construction methodology to be analysed/tested more accurately by investors, while indexes constructed with proprietary risk models are more akin ‘black boxes’.

Back-tests vs. live track record: this point is particularly relevant for some of the more recently launched factor and sustainable indexes where the performance and other metrics presented by the index providers are based on back-tests rather than live data. In some cases, the back-tested data might have been overfitted, and the risk-return profile of the index after launch might differ from the back-tests.

Rules-based strategy or an index: this point relates mainly to non-market cap weighted indexes, including factor and sustainable, when clients might opt either for a third party factor and/or sustainable index, or select market cap weighted index and achieve the factor exposures via screens and/or tilt on the portfolios, i.e. via a rules-based strategy.

Index provider selection

The requirements for market, size, and strategy exposure of the benchmark noted in the above section would typically influence the selection of an index provider. Index providers tend to offer their indexes in two main groups, local and global, as outlined below.

Local indexes are the so-called ‘flagship’ indexes covering a specific geographic segment. Examples include: S&P 500, Dow Jones Industrial Average, Russell 3000, FTSE 100, EUROSTOXX 50, DAX, SPI, etc. These indexes could be viewed as ‘stand-alone’ as they are not constructed with a building block approach in the context of the global investable universe – i.e., these indexes are favoured by investors aiming to gain exposure to a specific geographic segment via the flagship/blue chip local indexes associated with that segment. For example, if an investor would like to gain exposure to the US large- and mid-cap equity market, and are not interested in gaining exposure to other markets/size segments, they would likely consider S&P 500.

Global indexes aim to capture the global investable equity universe via indexes constructed by a building block approach, allowing investors to gain exposure to one, more, or all market and size segments globally without gaps or overlaps. These are suitable for investors who either want to gain exposure to the global investable universe from the onset of launching their index equity portfolio (via a global index) or gradually via combining different market and size segments (building blocks). MSCI Global Investable Market Indexes (GIMI) and FTSE Global Equity Index Series (GEIS) are some of the most popular global index series. In Exhibit we outline the typical building block approach in constructing global indexes.

Exhibit 3: Global indexes constructed via building blocks

In addition to mainstream, long established index providers such as MSCI, FTSE Russell, S&P DJI, and STOXX, there are more niche, specialist index providers such as Scientific Beta and Research Affiliates, focusing on construction of factor indexes, as well as index disruptors such as Solactive, offering high degree of customisation.

In addition to deciding on local vs. global index provider, investors should also consider index governance and commercial aspects as part of their index provider selection.

Index governance

Index provider reputation and longevity: once a benchmark is selected and applied to an index equity portfolio, it is very disruptive to have to change it for another index, especially an index from another index provider. Such change might be triggered by the index provider going out of business or having to rationalise index series due to low investor interest making these index series financially not viable. A due diligence on the index providers, including review of their ownership structure, financial position, and business plan, could provide insights on their potential longevity.

Research, data availability, and support: established index providers employ large teams of researchers conducting analysis on a variety of topics, including market structure, corporate events, risk premia factors, sustainability, etc. Availability of such research and databases is particularly relevant in the construction of custom indexes. Additionally, timely and comprehensive support from the index providers in answering investor questions is important, especially when the questions concern treatment of corporate events in the index, as these could impact the tracking accuracy and the value of the index portfolio. Data and analytics are increasingly important in light of the growth in factor and sustainable indexes, with many index providers buying specialist database, especially in the field of sustainable data. While such databases allow index provider to offer more customisation, such customisation tends to be restricted to the toolkit of the index provider.

Proven governance history: as indexes are rules-based strategies, transparent, unambiguous and robust rules related to their construction methodology, calculation policy, corporate events treatment, and rebalancing, are key for the efficient implementation and management of an index portfolio.

Commercial

Asset-based index licence fee and index data cost: with the continuing strong growth in index investing, index providers are trying to capitalise on this trend by charging asset-based index licence fees for the right to track their indexes (typically these fees are basis point-based fees applied on AUM) as well as custom index data fees for constructing tailor-made indexes (typically these fees are annual fixed monetary amount fees applied per index). These fees are payable by investors in addition to the management fee, and for larger size index portfolios index fees could dominate the overall fee. Fees vary between index providers, and could also be negotiable, hence, it is worth obtaining indicative fee quotes from different index providers.

Competing indexes: related to the above point on index fees, availability of competing similar indexes constructed by different index providers could potentially allow investors to select the most cost effective index.

Client interest: client interest in an index is important from two aspects. First, the more popular an index is, the more resources, support and maintenance an index provider would typically allocate to that index, and it would also be less likely such index to be discontinued. Second, the more assets track an index via index portfolios, the more impact there would likely be on the price formation of the basket of additions to and deletions from the index around index rebalance, and the more micro inefficiencies could potentially be exploited allowing to add incremental value to an index portfolio.

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