Indexes

Thank God for the wonderful opportunity of taking an MBA-level class on Equities and Related Products taught by Mr Mark Zurack - a guru on this subject matter. His in-depth understand of various investment products has made the class so fascinating and insightful. In addition, his poignant tips on trading and sales strategies are extremely valuable to me. This guy is a genius. Anyway, let's get back on track and talk about Indexes and Exchange Traded Funds. *Did I hear someone yawning?* Lol.

INDEXES: A PRIMER

"None of us is as smart as all of us." Anonymous quote hanging in the office of James Vertin, Head of Wells Fargo Management Sciences Department and bacvker of the first index fund - circa 1971.

What are they?

An Stock Index is a collection of stocks that usually represents the behaviour of a segment of the equity market. They are generally used as a:

a. Gauge of market sentiment (Wah lao, how come S&P500 down, US large caps must be KNS)
b. Basis for index funds (Wah, this year, my returns higher than S&P500 better pay me more bonus)
c. Benchmark for active management (Monkey see, monkey do.. anything wrong, nvm, everybody also kenna burn. i.e. wisdom of crowds/job protection? haha.. pardon my cynicism)
d. Proxy for asset classes in asset allocation (buy the index to get exposure to entire asset class)

Ideally, it should be able to serve all four purposes similarly, as added fungibility makes the utility of the benchmark that much greater. Indexes have come a long way since the launch of Charles Henry Dow's pioneering average in 1894 - and in particular, after the first index fund was launched in 1971. Nowadays, we are seeing a migration amongst investors towards indexing, away from usual stockpicking!

There are different kinds of indexes in the market today. There are Large-Cap Indexes (S&P500, DJIA), Small Cap Indexes (Russell 2000), Global Indexes (MSCI World), Foreign Indexes (FTSE100), Regional Indexes (Eurostoxx), Style Indexes (S&P/Barra Growth and Value), Industry Indexes (Goldman Sachs Technology).

These indexes are weighted in different ways: Market Capitalisation; Free Float; Price; Earnings. Generally, how the index is being weighted is something we need to know. This is because the performance of the index is really a result of the weighting!

Which one to invest in?

When selecting indexes to invest in, one must consider all their characteristics and determine which indexes best fit the needs of the investor. An index that is perfect for one investor could be completely inappropriate for another investor. For example, a narrow, highly liquid large-cap equity index would be an appropriate benchmark for a tradable index derivative or ETF, but would be inappropriate for use in asset allocation studies aiming to measure the risk/return of an entire stock market.

Remember, the question to ask is: Perfect for what use? Does the investor want a highly liquid tradable product for tactical allocation purposes or the maximum coverage of an asset class for strategic asset and liability modeling? Perhaps, what the investor really wants is a compromise between these two types of indexes!

Other considerations to look out for are the indexes' rebalancing approach and governance (this is an understatement!). With regard to the former, now that there is a critical mass of index investors, it is critical to know how the base-indexes are being rebalanced. You see, when a stock is added to or deleted from an index which has significant assets tracking it, those funds need to rebalance to reflect the change. Empirical evidence shows that assets managed against S&P indexes typically represent between 8-9% of the value of all US equities (the number jumps to 12% when other indexes are included). Statistics also show that on average, the act of S&P adding a stock into its index increases share price by 6-8%. I mean, we cannot afford to ignore this phenomenon!

Seven habits of highly effective indexes (lol)

Disclaimer: There are more than 7 gauges of effectiveness, but here are some of the key ones you can use as a framework to assess the indexes that you might be interested in.

1. Completeness: Does the index accurately reflect the overall investment opportunity set, both in terms of market cap-range/country coverage/company inclusion? Generally, the more complete an index (the broader and deeper its coverage), the more effectively it represents the investable universe for both active and index managers (also read: diversification maximisation).

2. Investabililty: Does the index include only those securities that investors can effectively purchase? For example, for non-US benchmarks, does the index screen out shares and market segments that are restricted for foreign investors?

3. Clear, Published Rules and Open Governance Structure: How transparent are the rules that govern the benchmark? Are these rules well established and publicly available? Such rules provide predictability to both portfolio managers and asset owners and makes it easier to anticipate how the benchmark will reflect changing market conditions.

4. Accurate and Complete Data: For an index to be useful, return and constituent data must be accurate, complete and readily available. Ask yourselves: Do you have access to: price/total/net dividend returns, consistent subindexes, high quality and efficient release of data, timely and transparent release of index changes, and historical returns.

5. Acceptance by investors: Investors generally prefer an index that is well-known and widely used. This gives investors faith in the index's ongoing integrity, since many market participants will scrutinise it.

6. Availability of Crossing Opportunities, Derivatives and Other Products: Widely used indexes, especially within pooled investment vehicles, offer potential cost savings because they provide crossing opportunities within the fund complexes of large institutional investment managers. This cuts out typical transaction costs you incur in the open market. Such indexes also generally create a more liquid, cheaper-to-trade OTC derivatives market, particularly in total return swaps. Basically, broad acceptance of a benchmark creates a network effect between fund managers, sell-side brokers, and the cash and derivatives market that reduces transaction costs for movement into and out of index portfolios.

7. Relatively Low Turnover and Related Transaction Costs: In general, a lower turnover results in a lower cost of rebalancing - thus, making the index easier to track. A rule of thumb is that, a broader benchmark favours lower turnover, while a narrowly defined index has greater turnover and greater transaction-related costs. An index with a predefined number of stocks (eg S&P500, Russell1000) have additional turnovers to maintain the fixed number of constituents.

There's a whole lot more to index funds. I suggest reading up on it at Investopedia. And please, tell me if I have gotten anything wrong, or missed out on something very fundamental. Thanks!