Indices are not transparent
Stock market indices are widely used in investment research, as proxies for market segments, as benchmarks for active investors and they underlie a range financial products including but not limited to ETFs, mutual funds, index futures and options. For retail investors, a given index may be synonymous with the market, and help them evaluate the performance of their own portfolio. However, regardless of the prevalence of stock market indices, I don't think they are that well understood by many investors.So, let us delve into the fascinating world of index construction. Let’s start by looking at a concrete example and move on to more general considerations. The Danish OMX Copenhagen 25 Index is maintained by Nasdaq and represents a selection of 23 (yes, there are only 23 companies included in the OMX C25) of the largest and most traded companies listed on the Nasdaq Copenhagen A/S exchange. To many Danish investors this index is synonymous with the Danish large cap market. One of the salient features of OMX C25 is that it is a weighted index capped at 15%, ensuring that no single issuer exceeds 15% of the total index weight. Were this rule in place on S&P 500, it would have no effect, as the largest index weight in S&P 500 is less than 15%. But in OMX C25, there is Novo Nordisk. Novo has a market cap of 606 billion USD in May 2024, and the combined market cap of all other 22 companies amounts to roughly 365 billion USD. The bulk of Novo’s market cap is produced by a steep rise in stock price that over the long run has significantly outpaced other members of OMX C25. However, given that Novo is capped at 15%, this impressive price performance is not captured by the index. To put numbers behind, the stock price of Novo has increased by 469% over the past 5 years, while in the same period OMX C25 has only increased by 79%. If one had invested in an ETF tracking OMX 25 5 years ago in the hope of some balanced exposure to Novo, one would indeed have missed out on the majority of Novo's stellar returns.
When scratching the surface of OMX C25, we realize that the inner mechanics of an index may significantly alter its returns, and as a starting point we may simply note that an index does not provide a transparent view into the performance of its underlying companies. In the remaining of this post we will take a deeper look at how indices are constructed.
Dimensions of Index Construction
Indices are typically constructed along a set of dimensions: market capitalization (e.g., Small Cap or Mid Cap), geography (e.g., European or Chinese), or sector (e.g., semiconductor or consumer goods). IN addition there are thematic indices, such as those focusing on women in leadership roles or innovation across industries. These dimensions are then often combined to create more advanced indices.A technical yet crucial aspect of index construction is how dividends are handled. What to do with the dividends payed out by a company in the index? Generally, there are four types approaches leading to different results.
Price indices: Dividends are not taken into account. The value of the index is solely determined by the stock price of the constituent companies.
Gross Return indices: Dividends are reinvested into the index without tax deductions. This captures the maximum possible returns from investments in the constituent companies.
Net Return indices: Dividends are reinvested into the index but after an assumed tax deduction. This mimics realistic investments in the constituent companies.
Dividend point indices: An index that measures the total dividend payment distributed by the constituent companies. This index is designed to capture the total dividend payout of the given stocks in a specific period.
So any stock market index can be of either of the four kinds with respect to dividends. For some markets this makes a significant difference over the long run. An example hereof would be the Austrian stock market which is dominated by a group of slow growing companies with high dividend yields. If we take the MSCI Austria Index (EUR) Price Return over a 10 year period, returns are around 35% as of May 2024. However, for the Net Return version of the same index, returns are 70%.
Another factor which can have huge repercussions for returns are currency exchange rates. Assume you live in Germany and have 1,000 Euros and decide to buy stocks in one of your favorite companies in the US. You convert your EUR to USD and buy the stock and wait one year, the stock remains flat, you wait two years, still nothing, after a third year of no significant price movement, you lose patience and sell the stock and convert back to the currency of your home country. On your bank account it says 1300 Euro. An acceptable return over a three year period. The stock remained largely flat, and while you thought nothing happened, the exchange rates did all the work. Currency exchange rates may work in your favor or they may work against you, regardless index construction have to take an active stance on how to approach currency exchange rates.
There are four main approaches to handling currencies within an index.
Standard currency indices: Convert prices and dividends to a base currency using real-time or daily rates.
Constant currency indices: Use a fixed exchange rate to the base currency at a certain point in time, typically when the index is created, and apply this rate consistently over the index’s lifespan.
Local currency indices: Create an index independently of a base currency. A constant exchange rate to a common currency is required in creation and re-balancing, but the index itself is not in a specific currency.
Hedged currency indices: Include both equities and currency components, aiming to measure equity returns alongside a strategic hedging approach.
Each approach has its advantages and drawbacks, and their utility varies based on what you aim to measure.
Consider a fund that uses an index as a benchmark for assessing the collective returns of a team of managers, each operating in different geographical locations and dealing in distinct currencies. In this scenario, a broad index calculated in local currencies might be preferable to mitigate the effects of fluctuating exchange rates. However, if the same fund also uses benchmarks for each manager individually, a standard currency index, aligned with the manager's investment universe currency, would be suitable.
For individual evaluations, the fund might employ a constant currency index to neutralize the effects of exchange rate fluctuations when comparing managers’ returns. However, a major limitation of constant currency indices is their inability to account for inflation, which is often reflected to some extent in a currency's exchange rates. For example, an index measured in Turkish Lira might show a tenfold increase over ten years. Although impressive at first glance, if this period coincides with high inflation, where the inflation rate also increased tenfold, the real returns might effectively be flat from the perspective of an investor based in Turkey. Typically, exchange rates would adjust to reflect such high inflation. While other factors like interest rates or quantitative easing also influence currency rates, exchange rates generally encapsulate inflation to a degree. Consequently, an index that does not adjust for these fluctuations fails to mitigate the impact of inflation. A more proactive approach would be to use a hedged currency index as a benchmark. This method involves hedging the currency exposure of the portfolio through sophisticated financial instruments like forwards and futures.
Ultimately, a fund might simply opt for a standard currency index in the reporting currency. After all, the goal is to optimize returns in that specific currency, and since it's impossible to completely avoid the effects of currency fluctuations, maintaining simplicity might be the best strategy. This is indeed probably how most retail investors reading this would feel as well. Why bother with all the intricacies arising from currencies and dividends. We know heard how hard it is to beat the S&P 500 anyway, so let’s stick to that as an ambitious goal. The S&P 500 is indeed typically quoted in price returns, and that seems to be difficult enough to match according to pundits. As a matter of fact, it’s common knowledge that beating the index is hard. In the next post we will take a look at why.
Summary
Indices play a crucial role in investment research and performance benchmarking for both active and passive investors. They serve as a proxy for "the market" for retail investors, helping them assess their portfolio's performance. Understanding the inner mechanics of index construction, including handling dividends and currency exchange rates, is essential for investors to utilize indices effectively in their strategies.I currently work for a capital association named Symmetry that has historically low correlation with major indices. If you would like more information about the association or just want to discuss the points in this post, please feel free to reach out.