Chapter 6

THERE’S AN INDEX FOR THAT

IF YOU WERE MAKING A LIST OF FINANCIAL INDICES, WHAT WOULD YOU INCLUDE? THE S&P 500^® AND THE DOW^®, NO DOUBT. YOU MIGHT ALSO INCLUDE LEADING MEASURES OF EUROPEAN OR ASIAN MARKETS, OR POPULAR SECTOR OR DIVIDEND INDICES. BUT YOU MAY NOT REALIZE THAT MILLIONS OF INDICES ARE CALCULATED EVERY DAY.

MOST INDICES FALL INTO ONE OF THE FOLLOWING CATEGORIES:

Equity indices
Fixed income indices
Commodity indices
Strategy indices
Economic indices

THE DIVERSIFIED INDEX LANDSCAPE

EACH OF THE LARGEST INDEX PROVIDERS PUBLISHES HUNDREDS OF THOUSANDS OF MARKET INDICES, COVERING THOUSANDS AND THOUSANDS OF SLICES AND SEGMENTS OF THE MARKETS.

You may wonder: Why does the world need so many indices?

More indices can mean increased flexibility in evaluating and tracking the markets. Analysts, for example, may use country and sector indices to determine what is driving the global markets, and pension funds can benchmark the performance of investments with very specific mandates.

For example, a pension fund could invest in socially responsible companies only, and index providers publish indices that specifically seek to measure the performance of companies selected based on socially responsible criteria. More indices also expand the opportunity set for investment product issuers to create ETFs and other tools that are useful to investors with varied interests.

Indices have methodologies ranging from straightforward to complex and cover asset classes including stocks, bonds, and commodities, among others.

EQUITY INDICES

WHEN MOST INVESTORS HEAR THE WORD “INDICES,” THEY THINK OF EQUITY INDICES—THE MOST FREQUENTLY QUOTED AND WIDELY AVAILABLE MARKET INDICATORS.

Stock market indices were also the first to be invented, more than a century ago. Today, investors have access to equity indices for nearly any market they can imagine

TRADITIONAL BETA INDICES

Some equity indices, including many broad market indices, are characterized as “plain vanilla” or “traditional beta” indices. This means that the index’s objective is to closely reflect the changing value of the market it tracks without layering on any special-interest screens or strategies. The broadest of these indices are designed to capture the performance of the entire global equity market. For example, the S&P Global BMI (Broad Market Index) covers approximately 10,000 stocks from 25 developed and 22 emerging markets.

More narrowly focused indices allow investors to precisely pinpoint specific market segments. For example, there are a wide range of country and regional indices that are subsets of the S&P Global BMI, as well as sector and industry indices such as those tracking energy, healthcare, and utility companies. There are also indices that break the equity market down into company size ranges such as large-, mid-, and small-cap (short for capitalization) companies.

Types of Sector Indices

Roll over to reveal the types of companies in each sector:

THEMATIC INDICES

Other equity indices track specialized themes. Their singular focus makes them distinct from, and sometimes more complex in terms of their methodology, than the traditional beta indices.

For example, the S&P Shariah Indices seek to include only companies that are considered acceptable for investment according to Shariah law. The component companies are identified using a series of published screens designed to eliminate businesses that offer products or services deemed unacceptable under Shariah law, or whose financial ratios (e.g., debt to equity) do not comply with specific standards.

As another example, the Dow Jones Sustainability World Index, one of a suite of sustainability indices created in collaboration with RobecoSAM, provides a benchmark for companies focused on sustainability around the globe. In this context, companies meet sustainability standards when they intend to increase long-term shareholder value by embracing opportunities and managing risks deriving from economic, environmental, and social developments.

FIXED INCOME INDICES

FIXED INCOME AS AN ASSET CLASS CASTS A WIDE GLOBAL NET.

Fixed income includes government bonds, such as U.S. Treasury issues, U.S. agency issues and municipal bonds, as well as the sovereign debt of countries worldwide. Fixed income also encompasses corporate bonds, including money markets, high-yield corporate bonds, leveraged loans, credit default swaps, convertibles, preferred stock, and sukuk, which are Shariah-compliant debt instruments.

Types of Fixed Income Instruments

Click to explore:

Indices tracking the prices and yields of fixed income securities may have less visibility than equity indices, but collectively, they track a significantly larger universe of securities than equity indices, both in the number of issues in the marketplace and their total market value in the U.S. and around the world.

For example, the S&P Municipal Bond Index tracks the vast U.S. municipal securities market, where investors hold debt valued at more than USD 3.7 trillion (Source: U.S. Securities and Exchange Commission). The size and complexity of the market supports a range of more narrowly focused indices whose investment universes are defined by maturity, rating, duration, specific use, and state of origin, among other factors.

Like equity indices, fixed income indices may serve as market barometers and as benchmarks for active managers. They may also be the basis of investable products—for example, ETFs, mutual funds and derivatives, including structured products—for the investing public.

COMMODITY INDICES

COMMODITY INDICES TYPICALLY TRACK THE PRICE OF A BASKET OF FUTURES CONTRACTS ON CONSUMABLE COMMODITIES—THE RAW MATERIALS OF INDUSTRIAL AND RETAIL PRODUCTS.

Changes in index value reflect, in aggregate, the changing prices of the underlying contracts on products as varied as oil, feeder cattle, and precious metals. The individual contract prices, in turn, are driven by a variety of factors, including supply and demand for their underlying commodity.

INDEX BASICS: COMMODITIES – HOW SPOT PRICES IMPACT FUTURES PRICES

Through exchange-traded products that track commodity indices, investors have access to an asset class that may sometimes be negatively correlated with equity and fixed income investments because the underlying commodity futures don’t always respond to changing economic forces in the same ways as stocks or bonds.

THE IMPACT OF CONTANGO

The futures contracts that a commodity index includes typically turn over regularly as the underlying contracts expire and are replaced with new contracts. The turnover schedule varies by commodity, and may occur as frequently as monthly for some components. One consequence of this structure is the index’s exposure to contango. This occurs when new contracts being purchased to replace expiring contracts are more costly, creating a potential long-term loss for investors in an ETF tracking the commodity index.

Broad-based commodity indices that track worldwide markets—such as the S&P GSCI and the Dow Jones Commodity Index—can serve as barometers of commodity market performance and as the basis of investment products. Other indices may have a narrower focus—for example those that track commodity sectors, such as precious metals, or individual commodities, such as copper or wheat. Specialized versions of commodity indices may aim to replicate a specific investment objective—for example reducing the weight of energy, or mitigating the risks of contango.

STRATEGY INDICES

THERE IS NOTHING VANILLA ABOUT STRATEGY INDICES. RATHER THAN PROVIDING STRAIGHTFORWARD MEASURES OF MARKET RETURN, THEY MIMIC A RANGE OF STRATEGIES, SUCH AS THOSE THAT AIM TO PROVIDE DIVIDEND INCOME, CONTROL RISK, OR ACCOUNT FOR OTHER MARKET FACTORS

While these indices are often based on traditional equity indices—for example, their constituents might be drawn from the S&P 500 or the S&P Global BMI—the indices’ defining features are distinctively their own.

Dividend Indices
Investor interest in dividend strategies has increased significantly in recent years, which has led to a proliferation of dividend indices. Various flavors of dividend indices are now available at the global level and for major markets within Asia, Europe, North America, and Latin America... more

While all dividend indices typically track a clearly defined universe of dividend-paying stocks, it’s not always the same universe and they don’t all take the same approach. For instance, some of these indices seek to include only those stocks that currently provide the highest yields. Others may put more emphasis on dividend history, for example, requiring that every stock in the index have a multi-year history of paying gradually higher dividends. Still others may seek a combination of consistent income and dividend growth. Less
Smart Beta Indices
Investment performance is driven by a number of factors, some of which help to enhance risk and return characteristics over time and others that may diminish risk and return. In selecting and weighting stocks for a factor index, sometimes referred to as a smart beta index,.. more an index provider typically focuses on constituents’ historically demonstrated characteristics, such as low volatility or intrinsic value.

A low volatility index, for example, focuses on stocks that have historically had more stable prices than the universe from which they are drawn and, as a result, have historically lost less value in downturns.

Index providers may also combine different factors to produce a multi-factor strategy index. For example, the S&P GIVI Global® (Global Intrinsic Value Index), whose objective is to achieve a higher beta than a market-cap-weighted index, screens its parent index (the S&P Global BMI) for low volatility stocks and then weights them by intrinsic value. The result is an index that capitalizes on two factors that have historically outperformed the market over long periods on a risk-adjusted basis. Less
Risk Control Indices
Broadly diversified market indices seek to measure non-systemic risk—the risk associated with individual companies. But market indices remain subject to the volatility of the market itself, or what’s described as systemic risk... more

One way potentially to limit market risk is to keep assets in cash. So index providers have developed innovative strategy indices, such as the S&P 500 Daily Risk Control Indices, that combine component allocations to both equity and cash to provide a specific level of risk exposure. Less
Asset Allocation Indices
Asset allocation indices track multiple asset classes—typically covering both equity and debt securities—in various combinations to reflect market performance at different levels of risk. Asset allocation indices are typically offered as a series of individual indices that share a single methodology... more

For example, the S&P Target Risk Indices represent a combination of asset classes chosen to measure consistent exposure to a specific level of risk, on a continuum from conservative to aggressive.

A specific type of asset allocation index known as a target date index gradually realigns its component securities over time in an effort to measure a portfolio with a decreasing level of risk as its target date, or end date such as retirement, approaches.

Investment products—specifically ETFs—linked to these strategy indices simplify asset allocation decision-making. Investors often use them in retirement savings accounts, such as a 401(k), or as an investment choice in a college savings account. However, since these products are tied to index performance, a positive return isn’t guaranteed, especially in a severe market downturn. Less

ECONOMIC INDICES

IN ADDITION TO INDICES THAT MEASURE MARKET PERFORMANCE AND MEET STRATEGIC OBJECTIVES, THERE ARE A HOST OF OTHER HIGHLY SPECIALIZED INDICES THAT SIGNIFICANTLY EXPAND THE SCOPE OF INDEXING.

Some of these indices focus on alternative asset classes, such as the CBOE Volatility Index^® (VIX)^®, which tracks expected stock market volatility. Unlike a conventional index, whose level reflects actual market performance, VIX seeks to reflect the anticipated movement of equity prices in the short term.
A very different example of what indices can measure is the S&P CoreLogic Case-Shiller Home Price Index, which serves as a benchmark of single-family home prices in the U.S. Given the importance of the housing market to the U.S. economy, these indices provide significant data on the changing values of representative properties.
Also having a major impact on the U.S. economy are healthcare costs. In fact, healthcare providers and policy makers need the data from indices such as S&P Healthcare Claims Indices to understand pricing trends, forecast growth, and set future rates.

All of these specialized indices, despite their diversity, share important characteristics with their more conventional kin. Namely, they are rules-driven and transparent and their methodologies and data are publicly available. Like conventional indices, they perform many of the same essential roles: they serve as benchmarks, provide research data, measure economic health, and, in some cases, underlie financial products.

An Investor’s Guide to Indicesindexology®