Indexes play a crucial role when it comes to investing.
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Index Education - Ch5 Intro
Expanding the use cases for indexes
There are some well-established use cases for indexes. For example, they are commonly used to compare the relative performance of active managers and as the foundational element for passive funds. As new investors enter the market and financial products continue to evolve, we are seeing new and expanding uses for indexes.
Using indexes as a starting point
Active managers may use the composition or constituents of an index as a starting point for their investment process. This can provide some efficiencies. The mapping of the investable landscape is already done so they can focus resources and attention in the implementation of their investment process.
Derived indexes are now also being used as initial universes for active managers. For example, factor indexes incorporate not only information on the investability of its constituents but also what stocks are representative of a specific style factor. Other derived indexes such as environmental, social and governance (ESG), climate and thematic indexes, include securities that fit the targeted investment style.
Incorporating indexes in structured products
Market or derived indexes can be used in structured products. These are investment products designed to obtain a possible return. They tend to incorporate more sophisticated financial instruments like derivatives, and are considered more complex than more traditional investments like mutual funds.
Structured products have been available for a number of years but have become more popular in recent times. There were more than $105 billion worth of structured products issued in the US in 2021, which was double the amount issued four years earlier1.
Addressing specific needs through client-designed indexes
There are times when institutional investors may need a client-designed index to reflect specific needs. These client-designed indexes may be used to:
- Better reflect asset allocation views
- Address an investor’s constraints on the ownership of certain market segments
- Incorporate additional liquidity and investability criteria
- Include specific regulatory guidance
While index providers have created extensive ranges to help address investors’ needs, it becomes challenging to anticipate all the different circumstances. Their needs may change through time, or they could include constraints that are transitory in nature. As a result, a temporary solution may have to be implemented.
This type of scenario could be encountered by public pension funds. In some countries, these investors are subject to government guidance on the type of assets they can hold. In Sweden, the Council on Ethics for Swedish National Pension Funds publishes a list of all companies they recommend the Swedish National Pension funds exclude from their portfolios. The funds may require certain companies to be excluded from their investable universe and, by association, from the indexes they use. These client-designed indexes will then be used by the asset managers that manage the pension fund assets.
Sometimes, institutional investors may have requirements that are linked to the characteristic specific to the asset classes. In fixed income, investors may require an index that focus on a specific maturity bucket (for example bonds that have a maturity of less than X years). Or they may want to exclude certain types of instruments.
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New uses of indexes (04:50)
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Index Education - Ch5 Intro 2
Personalising indexes to help wealth managers improve outcomes
The concept of personalization of investments has existed for many years. Technological advances have made it easier for wealth managers to monitor portfolios and engage with their clients to better determine their preferences and needs. Based on this information, the wealth manager defines the indexes they require.
We believe this is an extension of the customization and client-designed indexes that have been used by larger institutional investors. It is now available to a wider range of investors with varying portfolio sizes.
Tax optimization is another feature that wealth managers use when personalising investments. It is a rules-based technique that attempts to offset losses against portfolio gains. Wealth managers may choose to do this with the goal to improve outcomes for their clients.
Indexes contain a lot of information that is highly valued by institutional investors. We will continue to see investors explore their potential and identify new uses for them.
Index Education - Learn more about indexes
Learn more about indexes
Index Education - Chap 5 - enhanced cards
Index Education Chap 5- related content cards
Index Education - Ch5 footnotes
1WSD Group, SPi, “Structured products growth – where does it come from?” LinkedIn. April 27, 2022.