make money by choosing the right index

make money by choosing the right index

Selecting the right index is important and should be the first decision when investing in an index tracker, as it defines your investment universe.

As beta is the ‘market return’ associated with an asset class, it is most commonly accessed through index tracking funds. Indexing is a concept that began to attract investors seeking exposure, as opposed to outperformance, to the broad equity market – something not offered by traditional funds.

While market conditions have had a noteworthy influence on the soaring growth in beta investments, other key factors are driving an increasing allocation toward towards beta.

One such factor is that it is increasingly difficult to find active funds consistently delivering alpha, or market outperformance. More than 81% of active funds did not beat the S&P 500 index in 2011.

The range of beta products on offer is growing and provides covers many asset classes and market segments, offering diversification.

Beta strategies can also complement alpha. As investors alter the way they view their investment objectives, alpha and beta decisions are being combined in different ways.

How to define a ‘good’ benchmark

There are a range of factors you should consider when selecting a benchmark, which will depend on the application you are using it for. For example, the index should have an unambiguous and transparent methodology, in terms of how the securities and their weights in the benchmark are determined. How the index measure performance is also important, along with levels of withholding tax and exchange rates, among other considerations.

The index needs to be investable, meaning the securities should be liquid and therefore the benchmark easy to replicate. The securities in the index and its return should also be priced at least daily.

Having an index that has readily available historical data is useful, as is low turnover. An index with high turnover can make it difficult for a portfolio manager to track it when the underlying securities are frequently changing. 

Risk characteristics are also a consideration. The risk metrics of the benchmark should be published, so an actively managed portfolio can compare their risks to the benchmark risks.

Rapid growth in benchmarks

The types of benchmarks and their providers have grown rapidly over the past decade. Benchmark weighting is an important factor to consider because this will strongly influence the performance of the benchmark. Some of the more common types of benchmarks are:

• Market cap-weighted indices: this is the most common type of methodology, where the companies are weighted in proportion of their free float market cap to that of the overall market cap of all of the stocks in the index.

• Equal-weighted indices – these are less commonly used, and weigh each stock equally in the index. To keep the equal weighting of stocks these indices tend to have high turnover.

• Fundamental indices – these are a relatively new type of benchmark in which fundamental factors such as sales, book value, dividends, and earnings are used to determine the weights of the stocks in the index. Many have found these indices to have a value bias and higher turnover.

• Price-weighted indices: these are rarely used as benchmarks. They use only the price of each component stock to determine the index’s value.