Benchmark Selection

There's a widely held notion that index investing is only slightly less exciting than watching grass grow. Passive investors are content to sit back with a broadly-diversified, low-cost portfolio - and maybe an iced tea - and accept market returns.

But before they can reach that state of blissful nirvana, indexers must first make an important decision. "Passive" investing is in some ways a misnomer, because ultimately an investor must make the "active" decision of benchmark selection. Two of the biggest news stories of the year for indexers - the rise of index-linked ETFs and the yearlong MSCI switch to free-float index weighting - have highlighted the fact that not all indexes are created equal. Understanding the methodology employed to create and maintain a particular index is crucial if an index fund investor is to select a benchmark that best reflects his or her specific expectations of risk and return.

Benchmark selection is further complicated by the myriad of choices available. For example, this site lists the performance of hundreds of indexes, and we've just scratched the surface. Although it seems like we as investors have too many indexes already, the fact remains that index providers will continue to carve up the market in new and interesting ways because there is investor demand.

To help investors better understand international equity benchmarks, three investment strategists from Barclays Global Investors (BGI) - Steven Schoenfeld, Peter Handley, and Binu George - released a report earlier this year that identified seven key criteria when assessing these indexes. Below I've summarized those seven factors, and provided examples of why they are important today and looking forward.

1. Completeness - To be a true reflection of a particular slice of the market, the index should be an accurate representation of the returns of the overall slice, and therefore should reflect what BGI calls "the overall investment opportunity set." The importance of completeness is demonstrated by MSCI's decision to broaden its indexes to cover 85% of the market capitalization from the current 60%.

2. Investability - There should not be restrictions on the underlying stocks included in the index. Otherwise, tracking error and price squeezes will occur purely as a result of the selection of an uninvestable benchmark.

3. Clear rules and governance structure - In the sometimes incestuous world of index design, it is important to identify potential conflicts of interest between the index provider and index constituents. Also, it is essential for the index methodology to be transparent and publicly available. Markets change, and it's crucial for investors to be able to predict how those changes will affect a benchmark. For example, Salomon Smith Barney earlier this year pointed out that the ramifications of the MSCI switch to free-float could only be estimated because of the opaque nature of MSCI's index construction methodology.

"Just say no to those indexes you can't get your arms around and truly understand," said John Prestbo, Markets editor for the Wall Street Journal, at a recent conference on global sector investing.

4. Accurate and complete data - Performance analysis is one of the biggest reasons for using indexes as benchmarks, so it should therefore be widely available. That data should be made available on index provider websites.

5. Acceptance by investors - Not surprisingly, investors prefer indexes that are widely used and recognized. This is where marketing comes in. For example, as I've indicated, Salomon has been quick to criticize MSCI because Salomon's own international equity indexes have been float-weighted since 1989. However, that's been little vindication because MSCI has dominated in market share of international equity indexes. But who said the world was fair?

6. Crossing and derivatives - Widely-used indexes offer crossing opportunities for managers to reduce transaction costs. Additionally, the availability of derivatives products, such as futures contracts, increases liquidity and allows managers to hedge and secure better prices.

7. Turnover and transactions costs - Again, markets are not static, but fluid. Any index that is a true benchmark must reflect changes in the market. However, index rebalancing causes turnover, and turnover leads to transaction costs and tax inefficiency for index funds. Therefore, there is a tradeoff between index accuracy and the desire to avoid excessive transaction costs.

Several Key Criteria are Mutually Exclusive

The authors of the BGI report are quick to explain that no single benchmark can realistically fulfill all seven criteria because some are mutually exclusive. They identify some key tradeoffs. For example, a "complete" index would include all companies in its asset class. However, small companies trade infrequently and have low liquidity, and it is therefore not cost effective to own all of them. Index fund managers deal with this problem by taking a sample of the index the fund tracks. The Vanguard Total Stock Market index fund holds only about 3,400 of the most liquid Wilshire 5000 stocks, while tracking the index very closely.

Another important tradeoff identified by BGI is reconstitution frequency versus index turnover. Frequent rebalancings are a sign that the index is sensitive to changes in the market. However, as discussed above, this leads to turnover and transaction costs. Therefore, index providers seek a healthy balance between accurately reflecting the market and trying to keep turnover low.

Survival of the Fittest

When a fund manager licenses an index for an index fund, derivative, or exchange-traded fund, the index provider is normally compensated by receiving a cut (usually a few basis points) of the net assets within the product tied to its index. Competition between the index providers is stiff, and has only become more heated as passive investing strategies continue to develop and grow, particularly on the international scene.

If the law of the jungle applies, then only the indexes that meet the criteria listed above will attract investor dollars. That competition will lead to better-designed and more fund-friendly indexes, which ultimately benefits all investors.