Three indexers dominate the Equity Index space: S&P Dow Jones Index Group, its revenue is $639 million as of mid-2017; MSCI, its index segment revenues have climbed to $613.6m; and FTSE Russell, of which revenues from index business has been increasing significantly to be £409m (http://citywireusa.com/news/etf-providers-shun-big-brand-indices-as-price-pressure-mounts/a1023203/print). Within the fixed income or bond index vertical, Bloomberg Barclays Indexes unquestionably is the industry leader, with flagship index products such as the U.S., Euro, Asia-Pacific, and Global Aggregate Indices, U.S. Municipals, High-Yield and Emerging Markets Indices.
The bond index is distinctively different from equity index, so a separate section is allocated to describe the bond index construction method.
Equity Index Creation
Each indexer has his or her own total market index (TMI) as an initial security universe. For example, the S&P Total Market Index includes all eligible U.S. common equities. MSCI provides different sets of IMIs such as MSCI USA IMI Index, MSCI ACWI AC IMI. FTSE applies FTSE Global Equity Index Series, FTSE UK Index Series and the Russell US Equity Indexes.
First of all, eligible organizational structures and share types are: Corporations (including equity and mortgage REITs), Common stock (i.e. shares), Ineligible organizational structures and share types include: Business development companies (BDCs), Preferred Stock, Limited partnerships (LPs), Convertible preferred stock, Master limited partnerships (MLPs), Unit trusts, limited liability companies (LLCs), Equity warrants, Closed-end funds, Convertible bonds, ETFs, Investment trusts, ETNs, Rights, Royalty trusts, American Depositary Receipts (ADRs), Tracking stocks are eligible for the TMIX, but are ineligible for the S&P Composite 1500 and its component indices.
Then, a wide range of factors is taken into consideration to drill down to a narrower, more specific universe from the original TMI. Let us continue using S&P 500 as an example to explore. These factors include but are not limited to
- Market Capitalization,
- Public Float,
- Sector Classification,
- Financial Viability, and
- Treatment of IPOs
- Market Capitalization
Currently, unadjusted company market capitalization of US$ 6.1 billion or more is required for the S&P500 eligibility. The market cap of a potential addition to an index is looked at in the context of its short- and medium-term historical trends, as well as those of its industry. Index membership eligibility for a company with multiple share class lines is based on the total market capitalization of the company, including all publicly listed and unlisted share class lines, if applicable. For spin-offs, index membership eligibility is determined using when-issued prices, if available.
Adequate liquidity is a necessary feature. Using composite pricing and volume, the ratio of annual dollar value traded to float-adjusted market capitalization should be 1.00 or greater, and the stock should trade a minimum of 250, 000 shares in each of the six months leading up to the evaluation date. For companies with multiple share classes, each listed share class line is viewed independently to determine if it meets the liquidity criteria.
If it is a U.S. index, usually the component U.S. company has the following characteristics: files 10-K annual reports; the U.S. portion of fixed assets and revenues constitutes a plurality of the total, but need not exceed 50%. When these factors are in conflict, assets determine plurality. Revenue determines plurality when there is incomplete asset information; the primary listing of the common stock is NYSE, NYSE Arca, NYSE MKT, NASDAQ Global Select Market, NASDAQ Select Market, NASDAQ Capital Market, Bats BZX, Bats BYX, Bats EDGA, or Bats EDGX exchanges. ADRs are not eligible for inclusion; a corporate governance structure consistent with U.S. practice. There are caveats if certain criteria are not met while the company still can be defined as U.S. domiciled. Other factors including, but not limited to, publicly available ownership information and location of management and employees.
- Public Float
This criterion varies across different indexes. For S&P500, a public float of at least 50% of the stock is needed. For companies with multiple share class lines, each share class line is evaluated separately. Only those share class lines with a public float of at least 50% are considered for inclusion.
- Sector Classification
Contribution to sector balance maintenance, as measured by a comparison of each GICS sector’s weight in an index with its weight in the S&P Total Market Index, in the relevant market capitalization range.
- Financial Viability
The sum of the most recent four consecutive quarters’ Generally Accepted Accounting Principles (GAAP) earnings (net income excluding discontinued operations) should be positive. For equity real estate investment trusts (REITs), financial viability is based on GAAP earnings and/or Funds from Operations (FFO), if reported. FFO is a measure commonly used in equity REIT analysis.
- Treatment of IPOs
Initial public offerings should be traded on an eligible exchange for at least 12 months before being considered for addition to an index. (referenced from the S&P500 methodology guide).
Above outlined the first layer of index framework, on top of which, quantitative or qualitative security selection rules can be added. For example, MSCI minimum volatility index will be constrained by the Barra Volatility risk index factor. Another example, the MSCI KLD 400 Social Index, uses MSCI ESG Business Involvement Screening Research to identify companies that are involved in socially responsible business activities.
Lastly, when all the factors composing constituents are applied, the weighting of them is designed and will affect the fund performance. The classical way is market capitalization-based weighting, and it’s still the most commonly applied schema but is losing favor nowadays. The reason is quite obvious, this weighting tilts the portfolio/index toward large size companies, rendering the feature factors – minimum volatility, high dividend, emerging markets etc. – subdued instead of highlighted. In a mature market looking for alpha on top of market performance, this basic method is not catching up.
The equal weighted scheme was introduced early with considerably better performance, hence, a popular concept – “smart beta” is derived, and regarded a quasi equivalent to “equal weighting” index strategies. Gradually, the smart beta concept is broadened to all sorts of “smart” weightings that can be weighted equally and can be based on factors such as fundamental values, quantitative factors, and financial multiples etc.
Adding another layer of complexity, to avoid certain stock dominating the index makeup, the weight capping rules are commonly imposed during index creation. With this practice, top held stocks will be capped at a certain percentage, so they do not skew or bias the whole portfolio, and the additional weights are then allocated to the rest proportional to their original weight; this capping will be executed iteratively to ensure smoothness across the whole portfolio.
For example, the FactSet Natural Gas Index methodology mandates that individual security weight is capped at 22.5% and no more than two securities are at that cap. The excess weight of any capped security is redistributed proportionally among remaining securities whose weights are less than 22.5%. If this redistribution leads to additional security weights exceeding 22.5%, the aforementioned redistribution process is repeated iteratively until no security weight exceeds 22.5%. Next, the cumulative weight of all securities with an individual weight of 5% or greater shall not in aggregate exceed 45% of the weight of the index, otherwise, they will be capped in descending order, at either 4.5% or at a percentage that would bring the aggregate weights to be equal or greater than 45%, whichever is larger. The excess weight of any capped security is redistributed proportionally among remaining securities.
Any remaining non-capped securities with weights equal to or greater than 4.5% are capped at 4.5%. Excess weight is redistributed proportionally among remaining securities whose weights are less than 4.5%. The aforementioned redistribution process is repeated iteratively until all securities with 5% or greater weight do not in aggregate exceed 45% of the weight of the index. (reference FactSet Global FinTech Methodology Guide)