Tens of thousands of indexes were and are in the market, some are licensed to fund issuers with billions of dollar attached to, some other indexes are ephemeral, created and existed for a short lifespan and disappeared already.
In the former case, ETFs ranked by underlying AuM are as follows: SPDR S&P 500 ETF Trust (SPY), iShare Core S&P 500 ETF (IVV), Vanguard Total Stock Market Index Fund (VTI), iSahres MSCI EAFE ETF (EFA), Vanguard S&P 500 Index Fund (VOO), Vanguard FTSE Emerging Markets ETF (VWO), Vanguard FTSE Developed Markets ETF (VEA), PowerShares QQQ Trust (QQQ). SPY and IVV hold $238 Billion and $101 Billion respectively, QQQ also attains $46 Billion in the beginning of 2017. Both top two funds – SPY and IVV – track S&P 500 index, while the third fund VTI tracks CRSP US Total Market Index.
Either successful or short-lived indexes/funds, their methodology guides are similar: all composed of two major parts: construction or formulating an eligible universe, and the maintenance, accounting for rebalancing and dealing with event-related changes. It is worth elaboration on a third part: index calculation, which contains backtesting, the ongoing index value calculation, and currency hedging formulas. The next three chapters will address.
First, index construction or formulating an eligible universe. It is the key element for any index products. Usually, it starts with a basic applicable universe, then outlines the security selection rules that can be systematic, algo-based or manual scouring, selection requiring human judgment, and lastly describes the weighting schemes.
Second, index maintenance, which deals with rebalancing schedules as well as the buffering rules if applicable. The principle of dealing with event-related changes is always to minimize turnover rate, thus reduce transaction overheads. Depending on the indexer, management responsibilities, announcing rules, index dissemination etc.
Third, index calculation. We use S&P’s classical equation to dissect the pricing mechanism. The typical backtesting practice, rules, and currency hedging methods will also be explained.