How Are Indexes Constructed

Defining what to include

Constructing an index starts with deciding what type of securities to include. An index can include equities, fixed income, real estate, commodities, currencies and even other alternative investments such as private equity and hedge funds. The index provider may also want to focus on a subset. For example, within fixed income, it might target governments bonds or corporate bonds. Index providers typically set clear rules on what is eligible for inclusion, being mindful that markets and inclusion criteria may evolve.

Developing the right criteria

An index provider may include as many securities as possible within a market or market segment, knowing that the index may be used in the creation of a financial product. The index provider therefore develops ‘investability’ criteria. This is a way to assess how easily an investor would be able to purchase and sell the securities in the index.

The criteria may be linked to which securities are available for public trading, how frequently they are traded and how easily they can be accessed. They can be applied across different types of securities, but the unique traits of each typically account for some differences.

In equities, which are publicly traded instruments, most of the ‘investability’ criteria are based on readily accessible data and are more straightforward to calculate.

Fixed income securities do not trade on open exchanges, meaning their prices are less visible and they may not be as readily available for purchase. They may incorporate other criteria such as:

• Credit ratings (a measure of how reliable a company has been in terms of paying debt)
• Coupon (the interest investors in the bond will receive)
• Maturity (the length of the loan) and size (usually referred to as debt outstanding)

Gaining efficiencies and scale through frameworks

To help group securities and gain efficiencies and scale, index providers may create and implement classification frameworks and standards. For example:

• A country classification framework, to assign securities to a market which can be used to help create market, regional or global indexes
• A market classification framework, to reflect the economic development and market accessibility of each country (for example, a developed, emerging or frontier market)
• An industry classification, to reflect the primary business activity and help the index provider create industry-specific indexes

Frameworks and standards may be designed to avoid overlaps (companies classified in more than one category) and gaps (the standard is incomplete and falls short of covering the desired exposure or market segment). Institutional investors may find this feature useful when shaping and assessing investment portfolios. If there is double counting or missing information, it may have a detrimental impact.

The fixed income space is diverse and has even more frameworks and categories. Fixed income instruments can be issued by companies, governments or even regions or cities and grouped using metrics such as credit ratings.

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Sizing securities in an index

The most common way to weight securities is to look at the size of each index constituent. This is done differently across equities and fixed income.

Updating indexes is a balancing act

Indexes change as companies and markets change. Companies may go out of business, they may merge with other companies and new companies may be listed. In the case of fixed income, some bonds reach maturity while new ones get issued.

Index providers impose regular and systematic reviews/rebalances on their indexes. Getting the balance right is important: frequent enough to prevent an index from retaining stale data, but not too frequent to require constant turnover by investors.

In equities, due to their more permanent nature (a company could exist in perpetuity), indexes may be rebalanced two to four times a year. Bond indexes are generally rebalanced more frequently, as the universes of available bonds changes more often than equities.

Calculating index value and returns

To calculate the value and returns, index providers may set out an index calculation methodology.

The method defines how the aggregate average value of all constituents is calculated at any point. This is usually called the index value and incorporates the total market capitalization of all the securities included in the index. At its most basic, an index value is based on stock prices, which form the basis of the returns (price return index).

Equity indexes may also be designed to account for other returns, such as dividends. This leads to the calculation of total return indexes. As most of us live in a world where taxes are due on any gains, index providers may also calculate net returns indexes, which incorporate taxes. This is a closer representation of what an institutional investor would experience in terms of returns after taxes.

Similarly, in fixed income, you can have price returns and total returns. For example, bonds may pay coupons to investors which would need to be accounted for in the index return calculation.

Conclusion

You need both deep knowledge and a systematic and well-defined methodology to construct efficient and relevant indexes. To remain useful for investors, indexes are updated and rebalanced to reflect changes in companies and markets. How often depends on the type of index.