A short guide to index selection

It is estimated that more than three million indexes are calculated daily by the major index providers.¹ 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 2. 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.

• 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.

• 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.