SPECIAL REPORT: SHARE INDICES


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as arbitrary when trying to determine the true value of a stock, given that one company could price its shares at US$1 and have one billion shares, while another could have shares priced at US$1,000 and have one million shares, giving them both a US$1bn market capitalisation. Market capitalisation is now the


predominant method for constructing indices. Size matters, and a 1% change in a big company’s value is seen as more important in reflecting the overall direction of the market than a 1% change in the value of a small company. Indices can further refine the calculation by only including shares that are publicly traded. A company that is state-owned, for example, may part-privatise. If it sells 30% of the company on the stock market, many indices will only include 30% of the company’s value in their weighting: the state’s 70% will be excluded. Some criticise cap-weighted indices for


the distortions that can occur, though, such as the overweighting toward companies with the largest market capitalisation. Before a stock can have an influence


on a market, it needs to satisfy the selection criteria for inclusion in an index. With DJIA, the selection is made by Dow Jones Indices, meaning the companies included in the market are not always the largest. For the UK’s FTSE 100, and almost all other major indices, criteria include minimum free float requirements and a liquidity test (see cisi.org/indexchanges).


BENCHMARKING, ACTIVE FUNDS, AND PASSIVE FUNDS In a September 2020 CISI webinar on ‘Selecting an appropriate investment benchmark’, Daniel Broby, Chartered FCSI, chair of financial technology at Ulster University, explains that an index is “essentially an exercise in sampling, reducing an investment universe in a proportionate way, so you are getting a reflection of what you need”. This sampling allows active managers


to benchmark their performance, usually against a broad market index, such as the MSCI World or S&P 500. But they can also use a narrower index, or even peer group performance. Steve Kowal, head of EMEA Wealth Management at MSCI, recommends that investors check that their active manager is using a benchmark representative of what they purport to deliver.


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For example, “If you invest with an


active fund manager that uses a value process, and they outperform the MSCI World (which they use as their benchmark) by 1 percentage point, that might look okay,” he says, “but what if the active fund has only outperformed the MSCI World Value index by 20 basis points? If that’s the case, then you haven’t covered the costs of active management.” Essentially, if an active manager is


claiming that they pursue a certain style, then they should benchmark their fund against the most appropriate index so that investors can view the strategy’s performance against the most relevant comparator. Passive funds, meanwhile, aim to mimic


the performance of an underlying index. Indices form the basis of an index fund’s or exchange-traded fund’s (ETF’s) investment framework. A passive fund tracking the FTSE 100, for instance, will rise and fall in value in tandem with any ups and downs in the underlying holdings,


FIGURE 1: INDEX FUNDS HAVE GROWN AS A SHARE OF THE US FUND MARKET


Percentage of total net assets, year end


2011 TOTAL NET ASSETS: US$9.9 TRILLION 11%


9%


Index mutual funds Index ETFs Actively managed


mutual funds and ETFs


79%


2021 TOTAL NET ASSETS: US$29.3 TRILLION 20%


57%


23%


Note: Data for ETFs exclude non-1940 Investment Company Act ETFs. Data for mutual funds exclude money market funds.


Percentages may not add up to 100 due to rounding.


Source: 2022 Investment Company Institute fact book


THE REVIEW MARCH 2023


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