February 2012

CUSTOM INDICES: Worth their weight

SundaeIt is no longer all about market capitalisation when it comes to weighting stocks in indices. Stefanie Eschenbacher looks at trends in the customised index business. As clients’ demands increase, customised indices are becoming highly specific and increasingly complex, say some of the world’s biggest index providers. Momentum-based, volatility-based or income-focused custom indices are some of the most sophisticated new creations. Instead of weighting individual stocks according to their market capitalisation, they are weighted according to defined criteria, such as stock price movements or dividend payments. The MSCI World Index, for example, comprises 1,600 stocks from 24 developed countries, giving those with a larger market capitalisation more weight. Then there are various other indices derived from this parent index. The MSCI World Value Weighted Index, which weights all constituents of the parent index to emphasise stocks with lower valuations, is one. To determine the weighting of each stock, the team uses fundamental accounting data, such as sales, book value, earnings and cash earnings. Another is the MSCI World Risk Weighted Index, which weights each stock of the parent index so that those with lower risk are given higher index weights. The team uses three years of weekly returns to determine historic volatility. Following a slowdown in the years after the financial crisis, demand for such customised indices appears to have picked up. FTSE Custom Indices, MSCI Custom Indices, Russell Custom Indexes and S&P Custom Indices all report new orders. One of the drivers has been the development of innovative and competitive products by asset managers, for which a standard index is usually not enough. Instead, they choose to customise indices – be it as a base for structured products, a licence for exchange-traded funds or a benchmark for active managed funds. The client typically provides the methodology, while the index provider calculates and independently verifies the product.  “We see increasing demand for thematic strategies,” says Dimitris Melas, executive director and global head of new product research at MSCI. “Thematic and strategy indices tend to reflect a particular investment idea or approach.” These strategies combinethe advantages of passive funds – transparency, replicability and low costs – with that of active funds – the potential to outperform. Russell has been creating indices for the past two decades, adding dozens of new ones every year. In recent months, it has doubled its team responsible for Europe, the Middle East and Africa. Demand from the Middle East is up significantly, with sovereign wealth funds and many high-net-worth individuals diversifying away from private equity investments. Outside the United States, the UK is considered the second major hub of innovation. Germany is key for structured products, which use a customised index as a base. Gareth Parker, senior director of index research and design at Russell, says his team is spending more time than ever working on indices for investment strategies. “Originally, we created indices such as UK equities excluding tobacco companies,” he says. “Now they are becoming increasingly complex, like structured product indices involving China-based solar companies.” His team can create a relatively basic customised index in a few days, though this does not include the delivery and contractual agreements. An index covering the largest companies in the UK and France, but excluding tobacco companies, can be calculated in just two days. The more complex ones, such as African equities that meet certain liquidity criteria, can become “a research project”, says Parker. Marius Baumann, product manager, global custom indices at S&P, agrees that demand for customised indices has picked up.“Last year was one of the busiest in a good number of years. The complexity of indices has also increased.” He echoes Parker’s views, adding that institutional investors are looking for protection against volatile markets. “Every investment bank that we work with has developed its own methodology for volatility capped indices, so I would say three years ago, this did not exist. Today, all the banks will have this as part of their portfolio line-up. In terms of numbers, we created about 100 indices in 2011 that were themed around volatility protection.” For a dynamic asset strategy, one client commissioned an index with “built in triggers”, he says. Once this index reaches a certain level of volatility, allocation switches to equities or bonds. Société Générale, for example, has the SGI Asset Allocation Index, while Nomura has the Nomura Balanced Master Index. Another strategy that has become popular is based on volatility, for example, by giving stocks that have shown limited price movements a larger weight in the index. Baumann’s team created such a procedure for Citi Investment Strategies, which has developed an algorithm called the volatility balanced beta (Vibe) indices. He says these apply a risk-based weighting framework to various asset classes, extendable to long-only, relative value, absolute and relative risk-controlled applications. S&P has also created the Hybrid Custom Offering, which entails using an S&P index level or universe as part of the underlying index and then applying the client’s proprietary algorithm on top to achieve the results. Baumann says Chicago-based First Trust has been successful with this approach and has launched a family of indices, the Defined Index Series. Income-focused indices, which weight stocks according to their dividend yields or dividend payments, are also popular.
In 2011, Baumann’s team created 250 customised indices, more than in previous years, bringing the number to 6,000. The S&P 500 is the most customisable index S&P has, with roughly 600 indices derived from it. Though Sudir Raju, the managing director and head of custom indices at FTSE, says there is always demand for customised indices, he adds that thre thematic approach is “highly cyclical”. He expects demand for non-market capitalisation weighted indices to increase further. “We are going to see much more fundamental style-based indices using measures such as price per book dividends or responsible investment criteria,” he adds. Parker says many indices are already tilted towards certain markets; often emerging markets are given a larger weighting than in a standard index. One client commissioned an index from Russell that covers the top 100 companies in the UK, double-weighting those that had a rising price in the past five days. Another double-weights those stocks that showed high volatility. A Middle East-based client commissioned a sharia-compliant index, which includes stocks above a particular price earnings ratio. “If the client comes up with a rule, our customised index team can work it out,” Parker says, adding that his team has a flexible approach to client wishes. Other customised indices exclude stocks with a certain market capitalisation, restrict sector exposure or are weighted towards specific regions. Typically, clients choose to exclude sectors such as tobacco, energy or the top 50 companies by market capitalisation. Indices covering markets in the Middle East, for example, have a relatively large exposure towards oil and gas companies. Investors, however, often want to limit their exposure to one sector, or one single stock. If this is the case, they can choose to cap this exposure. There are limitations, though. When it comes to one company, such as BP, it is not feasible for the team to strip out the economic impact from the business carried out in America on the overall share price. Other strategies are feasible, but the outcome may not be useful for the client after all. “There is a conflict of perfect academic reflection of the market and investment pragmatism,” Parker says. “If we create a perfect index that contains companies the client cannot invest in, we are not helping him.” With the customised index business evolving and growing rapidly, it is more likely a new creation fails because the client cannot set definitions. ©2012 funds europe

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