ETF Evolution Conference: A Look Behind the Indexes

At the ETF Evolution conference, I was invited to moderate the panel for the session: "Index Construction and How It Relates To "Real World" ETF Products."

My panelists were esteemed senior members of the indexing world: Sanjay Arya, Head of Indexing at Morningstar, John Prestbo, Editor and Executive Director of Dow Jones Indexes, Jerry Moskowitz, President & Managing Director at FTSE Americas, and David Blitzer, Managing Director & Chairman of the Index Committee of Standard & Poor's. It was an interesting crew early Tuesday morning in NYC.

My biggest observation is that some of my panelists are real publishers and designing investment products is not on the top of their agenda. This is perhaps because of their longevity, size (meaning number of names) and being owned by publishing companies, rather than asset managers. I will post about this topic more over the coming days.

I was able to set the stage with a brief overview which is presented below. I attended most of the sessions and I am pretty much unmoved from my original thoughts. I broke my introduction into four segments.

What determines invest-ability?
I recently read several articles and blog posts published concerning tracking error and the potential lack of invest-ability in some of the stocks of many of the newer indexes. This includes some pretty mainstream or vanilla indexes in the U.S. and some well known indices in the international arena. I have also read posts about sector plays where small cap stocks come into the picture.

The question for the index developer is whether to include these smaller firms who may wind up being the future big winners, the Microsofts (MSFT), Motorolas (MOT) and Mercks (MRK) of the future, or to exclude them and potentially miss out on their potential stratospheric rise. Similarly, from a risk management stand point, by excluding these seemingly small players, the index designer may shield investors from their unceremonious tumble. Is it the job of the index designer to make these decisions or simply provide exposure to every firm? I do not believe so, as all index providers exclude firms on the pink sheets and other seemingly arbitrary exclusions.

Once the inclusion decision is made, for the stocks that do make the cut, this brings up other questions such as cap weighting, in which case the smaller players' contribution to returns may be so limited that inclusion may not be material on the up or down side, or choosing one of the many not so new, but now well publicized, weighting structures. The question remains: Will that which works best today be the optimal setting over 5, 10 and 20 years?

Niche versus broad appeal: The capacity issue
The question is no longer if niche indexes are here to stay. Providing low cost, liquid, traded real-time, used long or short, exposure to narrow asset classes is here to stay. In fact it makes this common-place institutional asset class available to investment advisors and individual investors, not just institutions. However, the warning labels on these products are an issue, along with how they best fit into portfolio construction techniques. Most asset allocation programs do not invite non-correlated asset classes to play.

With complete transparency and electronic trading, all investors now have access to many new and powerful products once only available to the largest investment funds and their institutional investors. Today, strategies that offer synthetic alpha through non-correlated investment strategies provide tremendous power tools to all types of investors. The fact is, these niche investment strategies have leveled the playing field of bulge bracket Wall Street Structured desks and are now available to sole practitioner financial advisors and individual investors. The 401k market is still yet not cracked, but it seems only a moment away until those saving for retirement through their company, union and government plans will have access to ETFs.

Liquidity versus return on individual securities
Liquidity is frequently measured in terms of number and amount of shares traded in the past month and quarter. Market Capitalization, float and percentage of institutional holders are also important factors when constructing an index. Clear Indexes has tracked NYSE listed firms that barely trade and stocks with $300 million market caps in great liquidity. This again factors into the inclusion of a stock in an index and the viability of the ETF issuer to work with its specialist to "print shares" that are backed up with the prescribed proportions of the underlying stocks. These issues surface again in terms of tracking error and capacity.

Where does the index designer's responsibilities begin and end and should there be substantive conversation between the parties involved?

Active versus passive: quantitative rebalancing or rules-based name changes?
The whole concept of rebalancing is an active manager's conversation until the quants moved from the lab to the front page of asset management. Yet does it make sense to reinvest, to rebalance to gain desired model-driven quantitative exposure? Do rules based name changes make for huge profits at arbitrage desks and hurt investors long-term? Does either of these techniques make sense for every index?

I believe that different types of indexes are better suited for different methodologies for name changes and each comes with tax and fee consequences. Additionally, firms go private, get acquired and de-list. When, how and why are replacements made?

Disclosure: The author is founder and CEO of Clear Indexes [CI] which creates and publishes custom indexes using a combination of qualitative research and quantitative methods. The indexes are used for custom institutional benchmarks and investment product design.