SPECIAL REPORT: SHARE INDICES
meaning the ETF can be wholly passive between rebalancing, thus keeping transaction costs and turnover low. Rebalancing – whereby index providers
remove firms that no longer meet the index criteria and replace them with ones that do – only occurs at index calculation dates when the underlying index changes, such as the quarterly rebalancing of the FTSE 100. Capitalisation weighted indices have low
trading activity and low turnover because constituents are only moved in or out of the index at set intervals, usually quarterly. For equal weighted or factor indices (the
latter of which are designed to only include constituents that express a certain characteristic, like momentum, volatility or yield), the index can change substantially between calculation dates, bringing higher trading activity, higher turnover, and higher costs. With factor investing, a phenomenon called ‘factor drift’ occurs, whereby the difference between a value-orientated index fund and the underlying index it is tracking become more disparate. This means that when a rebalancing occurs, it is often greater – and therefore more costly – than a market-cap rebalance.
EXTERNAL FACTORS A pronounced example of the effect of index inclusion on a specific share price relates to Moderna, the pharmaceuticals firm that shot to prominence during the Covid-19 pandemic. The firm’s inclusion in the S&P 500 was
announced on 15 June 2021, prompting its shares to rise by 6% even before its actual entry onto the bourse on 21 July. Researchers suggest that the ‘S&P effect’
– the upward trajectory in a firm’s valuation after the announcement that it will be included in the index – adds between 3% and 6% to a company’s valuation. This was also visible with Tesla, the
electric car maker, with its market capitalisation roughly doubling between the November 2020 announcement of its inclusion in the index and April 2021, according to an article published in The Review at the same time (
cisi.org/indices- powerful). Of course, there are stock- specific reasons that could have helped this notable rise, such as the company’s exciting growth prospects at the time. But there are some large rebalances
that take place that do not have a significant impact. Indrani De, head of global investment research at FTSE Russell, says the
CISI.ORG/REVIEW
rebalancing of a major index such as the Russell 3000 “doesn’t lead to unusual [market] volatility, because it is rules based and the process is designed to give investors considerable lead time before the actual index reconstitution takes place”.
// INDEX PROVIDERS ARE CONTINUING TO COME UP WITH MORE SPECIALIST OFFERINGS //
“Transparency is key to making sure the
market is not surprised about which constituents are going in and which are going out,” she says. “This rebalance is one of the biggest
trading events as we trade an entire index within a couple of seconds, but it causes minimal disruption and minimal volatility.”
TRANSPARENCY AND LIQUIDITY The seemingly unstoppable growth in passive funds is undeniably positive for index providers. Mark Northway, investment director at
Sparrows Capital, explains that the use of third-party indices requires passive funds to pay licence fees and asset-based fees (linked to the size of the fund) to the index provider, “but how much is very opaque”, he says. “The last time we looked at this issue, it
was almost impossible to identify how much was being paid by individual ETFs, as the fund manager tends to report a single fee for the management of the ETF, which covers the various things it pays for.” He adds that the picture is further
complicated by the fact this figure for management costs is often a net figure, which includes the income from stock lending. “In a world which has become transparent, with regulators disaggregating fees so that investors can see individual components, it is odd that in the ETF world you cannot get a picture of what is going on at a broken-down level, even in annual reports.” This lack of clarity may need to be
rectified if more sophisticated versions of passive funds, with more complex strategies and therefore higher costs that need to be disaggregated, become available to consumers. As it stands, index providers are
continuing to come up with more specialist offerings. This includes a whole host of different indices to cover ESG
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