THE KEY TO AN
ETF’s POWER?
AN “INVESTABLE”
INDEX
It is imperative that ETF product developers as well as fund selectors and analysts in the wealth space grasp how index selection can impact an investment product’s ability to meet its objectives.
UNDER THE HOOD WITH
MARK BARNES
HEAD OF INVESTMENT RESEARCH, AMERICAS, GLOBAL INVESTMENT RESEARCH, FTSE RUSSELL
WHAT MAKES
AN INDEX INVESTABLE?
Before embarking on any journey for an exchange-traded product, providers must consider core index construction tenets that serve as a strong foundation for investability.
When designing an index, practical, real-world implementation issues must be considered. It has to be investable, meaning an investment product replicating the index can be traded in the market efficiently, and at a high capacity.
1. Start with clear objectives
From the outset, ETF providers must define a clear vision of their goals, such as enhancing return, lowering volatility, or achieving targeted factor exposure(s). Then product providers and index engineers work together to map all the requirements and characteristics of an underlying index. Best practice is to design that index with a long view toward investability, ensuring the original objectives can be maintained over time.
EXAMPLE
The Russell 1000 Index has the objective of tracking the top 1,000 US equities by market cap
2. Accurate representation
improves investability
It is important to assess indexes from multiple angles—not just market performance. An index that effectively represents a market does so by delivering an unbiased, complete view of the market or market segment it is designed to measure. This is only accomplished through the application of an objective, transparent construction methodology. Arbitrarily excluding opportunities available to market participants can impact the weights of index members. Differences in weights and returns can impact index performance.
The introduction of constraints can be a useful safeguard against any unwanted extreme positions. In other words, an investable index must be “true-to-label.”
EXAMPLE
The Russell 3000 Index represents the top 3,000 investable stocks in the US stock market
3. Diversification mitigates
concentration risks
To achieve a stated objective, any index runs the risk of becoming overly concentrated. Naturally, its design can start to resemble active approach relative to the market capitalization of the benchmark. Ensuring appropriate levels of diversification within an index can mitigate potential sector, country, or stock-specific concentration risks.
EXAMPLE
FTSE Global RIC Capped Indexes were built to help investors meet concentration and diversification requirements
4. Design methodology can make a big difference
Index providers differ in their build methodologies. Each brand brings their own toolkit to design for particular objectives. In the process, trade-offs are made along the way: targeted factor exposure vs diversification, simplicityvs complexity, etc.
Investability relies on the most efficient methodology that most closely meets the stated objectives.
EXAMPLE
FTSE Fixed Income Indexes are designed to appeal to a broad range of market participants and are widely followed by the investment community
5. Replicability is key for investability
A popular criticism of the latest generation of indexes (e.g. smart beta) is they rely on theoretical academic analysis and on back-tested data to simulate attractive performance outcomes. Investability relies on practical, real world implementation issues; i.e., an investment product replicating the index can be traded in the market efficiently, and at a high capacity. Index design addresses many questions, such as: Can the fund manager trade the number of stocks? Is that market segment liquid enough? What are the turnover and likely trading costs? The most investable indexes are tempered by reality.
EXAMPLE
The Russell 2000 Index aims to accurately measure the performance of the small-cap segment of the US equity market