ETF Investing: Make Sure You Know Your Index (I)

Understanding your ETFs' underlying indices and choosing the appropriate one to achieve the desired investment objective is crucial.

Morningstar Analysts 03 May, 2012 | 0:00
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For exchange-traded fund investors, understanding products' underlying indices and choosing the appropriate one to achieve the desired investment objective is a crucial piece of the investment process. The following article will help investors better understand the different nuances of index construction by highlighting the various methodologies used to construct an index as well as their specific advantages and disadvantages.

Index Definition
Before delving into the index construction, let’s take a step back first and define an index.

An index is a statistical measure representing the aggregated market value of its constituents. Each index represents a particular market, e.g. STOXX Europe 600 Index, or a portion of it, e.g. STOXX Europe 600 Financial Services Index, and therefore serves as a barometer for this market or industry. Indices can use different calculation methods which we will discuss in more detail in the next section.

Index Construction
The details of how the indices underlying ETPs are built are all too often overlooked. Weighting methodologies, rebalancing and reconstitution frequency, caps, and a host of other factors will all have implications for an ETP’s performance, its cost, and how it will fit within a broader portfolio.

First, we introduce the most commonly used weighting method – market-capitalisation weighting.

Market-Capitalisation Weighting
Float-adjusted market capitalisation weighting is the most common index weighting methodology and is firmly rooted in the tenets of modern portfolio theory. This method reflects the weighting of the security in relation to the aggregate size of its relevant market. Because closely held firms will have a smaller piece of their aggregate market capitalisation floated on public exchanges, the float adjustment serves to ensure the underlying liquidity of the holdings is superior relative to a pure market capitalisation weighting.

The easiest risk to spot in most indices is that of excessive concentration in a given constituent or number of constituents or perhaps in a specific sector. The MSCI Brazil Index is a prime illustration of concentration risk from the perspective of both individual constituents and sector representation as the index is very top-heavy, with its top-five components accounting for about 40% of its value. It is also highly concentrated from the perspective of sector exposure, with energy and materials firms representing almost half its value. Oil giant Petrobras and mega-miner Vale comprise 32% of the index’s value. In many instances, index providers have introduced caps on the weighting of individual constituents in order to avoid undue concentration. For example, the Hang Seng Index caps the value of any individual constituent at 15% of the index’s total. This prevents bank giant HSBC from representing a massive portion of the index’s value.

Index-weighting methodologies can introduce certain biases that are also important to understand. For instance, market-capitalisation-weighted indices will by their very design tend to increase their allocation to those constituents that have increased the most in price and reduced their exposure to laggards over time. This introduces an inherent growth/momentum bias that is necessary to acknowledge.

During times of severe market dislocation, such as the technology bubble of the late 1990s, this inherent bias can lead to excessive concentration in the market’s most overvalued shares. Meanwhile, in the case of market-capitalisation- weighted fixed-income indices, market-capitalisation weighting can lead to excessive concentration in the obligations of highly leveraged, less creditworthy borrowers.

In part II of this article, we will be introducing other three weighting methodologies: price weighting, equal weighting and fundamental weighting.

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