Innovation in equity indices allow investors to slice and dice the market: Learn how to tailor your exposure.
How do I decide which companies to invest in?
Most people don’t have time to break down financial statements and track earnings to make these decisions.
Fortunately, equity indices make the task extremely simple (and cheap). Better yet, studies show you’ll finish ahead of most stock pickers.
The best way to understand equity indices is to get an idea of how they are built.
The first step in creating an index is to define an eligible universe of securities. The eligible universe is a group of stocks that meet a certain criteria. The criteria could be company size, country of domicile, sector of operation or anything the index provider wants.
If you wanted to build an index of the entire UK equity market, then the eligible universe would be all UK equity securities—which could be defined in various ways.
The more granular or specific you get, the more specific your selection universe gets. A Chinese energy index would only select from a universe of Chinese energy companies.
Defining the eligible universe can range from extremely simple and straightforward to complex and convoluted. Fortunately, the index provider does that for you. You just need to decide if their view coalesces with your own.
After all, there is no universal definition of a small-cap firm, or an energy company or an emerging market country. Virtually every decision in the selection process is up for debate, and the rules that govern those decisions will often vary greatly by index providers—even for two indices that capture the same market.
For example, two of the most popular emerging markets indices take different views on South Korea: MSCI considers South Korea an emerging market, while FTSE considers it developed. The decision has real portfolio impact, as South Korea makes up roughly 15% of the MSCI index and 0% of the FTSE index.
Similarly, but from a sector perspective, Amazon is a “technology” company according to one index provider, and a “retail” company according to another.
You don’t need to have an opinion on each topic, but the information is there in case you do have a preference.
Once the index has decided which companies to include, the next major decision is how much of each to hold: its weighting scheme.
Market-capitalization (market-cap) weighting is the most common weighting scheme, and is also considered to be the most neutral. It’s considered the most neutral because under this scheme, the largest firms—as measured by market cap—are given the highest weightings. See “Market Cap Indices” for more information.
Other weighting schemes include:
Equal-weighting: Each company in the index receives the same weight. (See “Equal-Weighted Indices”for more information.)
Dividend Weighting: Emphasizes companies with largest dividends. (See “Dividend-Weighted Indices” for more information.)
Volatility Weighting: Highest weightings to least volatile securities. (See “Low-Volatility Indexing” for more information.)
Fundamental Weighting: Assigns highest weights to companies with strongest fundamentals. (See “Fundamental Indexing” for more information.)
Each weighting scheme has its own advantages and disadvantages, and each serves to emphasize different company characteristics such as size, volatility, revenues or distributed income.
Bringing It Together: Picking An Index
So, when you’re trying to decide which companies to invest in, consider turning to indices and investable index products as a solution. After all, picking an index is far simpler, requires lower maintenance and is a likely more fruitful route than analyzing, selecting and following individual companies.
If you decide to go the index route, the first decision to make is your eligible universe. Then think about how to define that eligible universe, as various indices will have different methods to determine which companies fit the bill.
Next, decide if there is a company characteristic such as volatility or dividends that you would like to emphasize. If not, stick with market-cap weighting.
The final step is to find an ETP or index fund that tracks your index of choice. It’s really as simple as that.
From there on out, the ETF and the index do the work for you (for a small, sometimes trivial, fee). They decide when to rebalance the portfolio, which companies to add or remove, and the relative size of each company in the portfolio. You just kick back, relax and decide when you would like to buy more or sell out.