When investing in US equities, choosing the right benchmark is job #1, says Gareth Parker, senior director, index research, design and development, at Russell Indexes Emea.
Market indexes serve two main purposes for investors: for portfolio analysis for active investors, that is to assess portfolio composition and gauge relative performance; and for passive portfolio construction to gain exposure to a certain asset class or investment style through an index-based investment product. In both cases, how the index is constructed can mean the difference between successful investing and potential disappointment.
Market benchmarks today cover nearly every major global equity market and investment style. The global multi-asset investor has access to an extensive, accurate and higher quality set of index tools across nearly every major asset class, market and capitalisation. Understanding the differences among indexes can be the most critical step in choosing the right one for gaining desired market exposure and understanding multi-asset portfolio performance. Below are three key characteristics investors should look for in a market index:
To measure an investment manager’s performance, a benchmark needs to include the manager’s entire selection universe. For investors, the omission of part of the investment opportunity set can lead to an inaccurate market measure, gaps in intended exposure or potentially foregone gains. It is critically important that a market index includes no gaps or biases.
OBJECTIVITY AND TRANSPARENCY
Investors need clear insight into how an index is constructed. A key question is whether an objective, rules-based approach is used, or whether index constituents are determined by the subjective decisions of a committee. A subjective approach may distort the intended market exposure an investor is seeking rather than provide transparent market exposure. This may lead to unexpected outcomes for investors due to higher tracking error relative to their market. Not all major US market indexes are run according to a fully rules-based approach.
Investors need to understand whether constituents of the index are readily available to them and how easily they can be bought and sold. Constituents that are less liquid or navailable can make it more difficult to replicate an index, resulting in higher tracking error and a potential failure to deliver consistent exposure to the intended asset class.
With *$4.1 trillion (€3.16 trillion) in benchmarked assets globally, more institutional funds track the Russell Indexes than all other US equity indexes combined (72%). Of the ten most used US equity benchmarks for institutional assets, nine are Russell Indexes. In the US small cap space, 97% of institutional products are based on the Russell 2000® Index Series.
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