browser Warning Icon You are using an older version of Internet Explorer. You are viewing this site with limited functionalities.

Chapter 5

Methodology Matters

INDEX METHODOLOGIES CONTAIN THE RULES THAT DICTATE HOW AN INDEX FUNCTIONS AND ULTIMATELY HELP TO DETERMINE HOW IT PERFORMS.

THE FOUR MAIN COMPONENTS OF INDEX METHODOLOGIES

  • Construction: How securities are selected to achieve the index’s intended exposure
  • Weighting: How index components are weighted relative to one another
  • Calculation: How index values and returns are generated
  • Review: How the index is maintained on an ongoing basis

THE INDEX BLUEPRINT

IF TWO INDICES TRACK THE SAME MARKET, YOU MIGHT EXPECT THEIR RESULTS TO BE THE SAME, BUT THAT’S RARELY, IF EVER, THE CASE.

Unless indices use precisely the same methodology, their actual returns will differ, sometimes significantly. So understanding the methodology an index uses, and the impact it can have on performance, is especially important for the growing number of investors whose holdings include index-based investments.

Broadly speaking, an index methodology is a set of rules or criteria that govern an index’s creation, calculation, and maintenance. The rules determine the securities that are eligible for inclusion in the index, the formulas by which the index value is calculated, the process for modifying the components, and a timetable for updates.

Index methodologies can be complex, but they’re not a mystery. In fact, one of the core characteristics of an index methodology is typically transparency. Most prominent index providers make the methodologies for their indices publicly available, ensuring that the indices can be replicated.

From an investor’s perspective, it is important to realize that an index’s methodology is the blueprint that ultimately determines the index’s characteristics and the performance it will deliver. That’s why, in selecting among ETFs whose underlying indices appear to represent the same exposure, a potential investor should understand the key elements of each index’s methodology. Only then can an educated decision be made about which ETF to choose based on individual investment goals.

CONSTRUCTION

A KEY PART OF AN INDEX METHODOLOGY IS THE SET OF RULES THAT GOVERN THE INDEX’S CONSTRUCTION.

These rules define what securities are included in an index, and which are excluded from it. In creating these rules, index providers account for two key considerations:

The intended use of an index may be to benchmark portfolio performance, underlie an investment product, such as an exchange-traded fund (ETF) or mutual fund, support research, or a combination of these uses.

Market demand may drive the impetus to create an index or the motivation may come from the index provider, whose team of experts has identified an opportunity to track a particular market or a specific investment tactic or strategy.

The intended exposure could be almost any market segment that’s trackable. For example, the index might seek to track the securities of an asset class, subclass, or sector. It might focus on a single country, a combination of countries with similar economic or geographic characteristics, or the global marketplace. It might identify a strategic or thematic objective, such as dividend income or risk management.

The intended exposure determines the index universe, which is the broadest possible set of securities or other asset classes that could potentially be eligible for the index. A primary consideration in defining a universe is that there must be publicly available prices for the types of assets that the index would potentially include. These prices are essential for reliable index calculation.

ELIGIBILITY AND SELECTION CRITERIA

Eligibility and selection criteria determine which securities are eligible for and ultimately included in an index. Typical criteria include a security’s market cap, the location of the issuer’s corporate headquarters, and the currency or currencies in which the security is denominated. For example, the criteria might specify that all U.S. stocks with a market cap of USD 5 billion will be eligible for the index, or that only technology stocks are eligible.

Liquidity, a measure of how frequently an asset or security is traded, is often a key criterion of eligibility. If the intended use of an index is to underlie an investment product, liquidity may be a key determinant of how readily a product provider wishing to replicate the index could purchase the asset for the product’s portfolio. As a result, illiquid or thinly traded securities that might otherwise be eligible for an index may be excluded.

Depending on the intended use and intended exposure of an index, the criteria might screen for other factors, including financial characteristics or fundamentals, such as price-to-earnings ratio or dividend yield.

The types of criteria that can be used to screen stocks vary widely. Shariah indices, for example, exclude stocks from companies that produce goods or services that may be unacceptable to Muslim investors. Sustainability indices may exclude companies that fail to meet minimum standards based on environmental criteria.

Once a set of eligible assets has been identified, many index methodologies rank them based on one or more selection criteria, and choose only the top qualifiers as index components. For example, the S&P 500 generally selects the largest U.S. securities based on market cap, once other eligibility criteria are met.

Making the Cut:
How stocks are selected for the Dow Jones U.S. Dividend 100 Index
Universe2,500 largest U.S.-traded stocks based on market capitalization, excluding REITs Dividend History ScreenMust have minimum of 10 consecutive years of dividend payments Size ScreenMust have minimum float-adjusted market capitalization of USD 500 million Liquidity Screen Must have minimum three-month average daily trading volume of USD 2 million Dividend Yield ScreenMust be within top half of securities by indicated annual dividend yield Fundamentals-Based SelectionRemaining stocks are ranked by cash flow to debt, return on equity, dividend yield, and dividend growth rate. The stocks ranked highest are selected for the index.

WEIGHTING

ONCE THE INDEX COMPONENTS ARE SELECTED, EACH ASSET IS ASSIGNED A WEIGHT THAT DETERMINES THE RELATIVE INFLUENCE THAT SECURITY WILL HAVE ON INDEX PERFORMANCE.

To understand how weighting works, consider the Dow Jones Industrial Average®, which uses a very simple weighting method: price weighting. If GE, a constituent of The Dow®, had a share price of USD 35, and the sum of the share prices of all DJIA component stocks was USD 1,500, then the weight of GE in The Dow would be USD 35/USD 1,500 = 2.3%. If Nike, another DJIA component, had a share price of USD 70, it would have a weight of USD 70/USD 1,500 = 4.6%. Because the weight of Nike is twice that of GE, a 10% change in the share price of Nike would have twice the impact on the performance of The Dow that a 10% change in the share price of GE would.

While price weighting is the simplest type of weighting method, it is not commonly used. The more typical weighting methodologies account for factors other than stock prices.

How Does Weighting Impact an Index?

See how an index's composition changes depending on how it's weighted.

WEIGHTED EQUALLY

If an index is equal-weighted, all component stocks have the same impact on index performance.

WEIGHTED BY PRICE

If the index was price-weighted, Company A would have the greatest influence on index performance, because it has the highest stock price.

WEIGHTED BY MARKET CAP

If the index was market-cap weighted, Company B would impact the index performance the most, since it has the largest market capitalization.

Company Stock Price Shares Outstanding Market Capitalization
A 159.08 X 206,240,000 = $32,808,659,200
B 106.48 X 517,521,740 = $55,105,714,875
C 13.61 X 439,280,860 = $5,978,612,505
D 62.22 X 386,234,640 = $24,031,519,301
E 50.37 X 98,118,740 = $4,942,240,934

CALCULATION

KNOWING HOW AN INDEX IS CALCULATED CAN HELP INVESTORS UNDERSTAND HOW IT MEASURES MARKET PERFORMANCE.

Index values are calculated and disseminated as frequently as once every second throughout the trading day. Behind each of these index "ticks" is a set of standardized approaches, formulas, and calculations.

How is an Index Value Calculated?

Click to reveal how a typical market-cap index might be calculated.

STEP 1: Each stock's market capitalization is calculated by multiplying its current price by its number of shares outstanding.

STEP 2: The index market capitalization is calculated by summing the market caps of the constituents.

STEP 3: The index value is calculated by dividing the index market capitalization by the index divisor.

Company Stock Price Shares Outstanding Market Capitalization
A 159.08 X 206,240,000.00 = $32,808,659,200
B 106.48 X 517,521,740.00 = $55,105,714,875
C 13.61 X 439,280,860.00 = $5,978,612,505
D 62.22 X 386,234,640.00 = $24,031,519,301
E 50.37 X 98,118,740.00 = $4,942,240,934
Index Market Capitalization $122,866,746,814
Index Divisor ÷ 34,938,376
Index Value = 3,517

An index's return can be calculated by comparing the index values from one period to the next. For example, if the index value were 1,878.48 at the close of trading one day and 1,894.86 at the close the next day, the difference of 16.38 would indicate a 0.87% gain in value.

BACK-TESTED PERFORMANCE DATA

Using the rules established by the index methodology and historical records about the universe of securities that existed in the past, index providers can estimate how an index may have performed had it existed prior to its introduction, or “launch date.” However, it is important to recognize that back-tested data is theoretical only and not the same as live data.

THE DIVISOR IN ACTION

The divisor is key to index calculation. It’s an arbitrary, though usually publicly available, number that is set at the time an index is launched. The divisor is used as the denominator in the equation for calculating index level where the numerator is the cumulative market value of the securities in the index. Because the numerator value can easily be trillions of dollars, the first thing the divisor does is to scale, or reduce, that figure to a comprehensible number.

Even more importantly, the divisor is the means for maintaining a continuous measure of market valuation, even as the list of index components is modified and the floating shares for various securities are adjusted. This continuity is possible because the divisor is regularly adjusted to compensate for any changes other than share prices that would affect the index value. Such changes may include rights offerings, spin-offs, and special dividend payments.

In addition, any adjustment to the divisor is made after the close of trading. As a result, the closing value of the index before the change is the same as the opening value on the next trading day, assuming that the prices of the component securities stay the same.

Divisor adjustments to equal-weighted and price-weighted indices differ from those for cap-weighted indices. However, the principle of maintaining a constant index level irrespective of changes to index components remains the same. For example, in a market-cap-weighted index, an adjustment isn’t required for stock splits because the market value of the security remains the same. However, with a price-weighted index, an adjustment is required because price — which might be half or less of what it was before the split — is the operative factor.

TYPES OF RETURNS

Equity and fixed income indices are most typically calculated as either price or total return indices. Many indices, including the S&P 500, are calculated both ways.

In a price-only calculation, the changing value of the index reflects the changing prices of its component securities, or unrealized capital gains and losses. In a total return index, on the other hand, the changing value is determined by a combination of the price changes and reinvested income from dividends or other cash payouts. This means the total return on an equity index in which any of the components pay dividends will always be higher than the price return.

Calculating the total return of an index differs from calculating the total return of an index-based product, such as a mutual fund, where dividend income is reinvested to buy additional shares. In an index, the dividends become an additional factor in calculating the changing level of the index.

Commodity indices may be calculated as total return or excess return, or as spot indices. For an example of how these return types are calculated, see the S&P GSCI methodology.

REVIEW

AN ESSENTIAL PART OF AN INDEX METHODOLOGY IS ENSURING THAT AN INDEX REMAINS CONSISTENT WITH ITS OBJECTIVE.

This requires changes in the roster of index components over time, with some securities added and others dropped. In addition, share counts typically need to be updated to reflect the actual number of shares available for trading.

For most indices, security deletions and additions happen concurrently, during regular rebalancing, typically scheduled on a quarterly or annual basis. At that time, the index provider essentially repeats the selection process to choose the securities that best meet the criteria established in the methodology.

Most index deletions take place when a company fails to meet the eligibility requirements of an index, or becomes outranked by other companies based on the index’s selection criteria. Other deletions are required because the issuing company has been acquired, taken private, or merged with another company. In each case, the basis for removal is made clear.

Additionally, most index methodologies provide for securities to be dropped from an index between scheduled reviews in the event of a major corporate action, such as a delisting or bankruptcy.

Congratulations

You've completed chapter 5. Now, test your knowledge by taking a brief quiz.

Take the quiz

Select the best response to each question and click "Submit" to view your results.

    • Stock splits
    • Earnings announcements
    • Spin-offs
    • Dividend payments
    • Securities are added and removed
    • Component weightings are reestablished
    • The index level is reset to 1,000
    • A and B
    • Market capitalization
    • Liquidity
    • Price
    • Fundamentals
    • To exclude shares that are closely held by governments, families, or individuals such as company founders
    • To represent the number of shares that are readily available for public trading
    • To adjust market capitalization weightings to more realistically represent the composition of the market
    • All of the above
    • Equal weighting
    • Market-cap weighting
    • Price weighting
    • Fundamentals-based weighting
submit
cancel