Whether serving as a long-term core holding or as a means of quickly repositioning a portfolio, its main appeal is that index investing putatively offers market exposure and risk diversification in a cost-effective way.
There are various ways to construct indices, although none is ideal and the degree of bias can pose challenges. The most common involves weighting by capitalisation or size. While the index make up can be seen as reflecting the success of its constituents, it is likely to fall short of a sensible approach to risk.
There are well-known examples of indices becoming skewed – the Finnish Hex by Nokia, the technology-heavy Nasdaq by Apple and the European bond indices by Italy.
The danger can be seen in the long-term derating of Nokia echoed in the Hex, a 14 per cent fall in Apple resulting in a 7 per cent decline in Nasdaq and the bankruptcy of some investors following the rebalance of the commodity index.
Benchmarks can be constructed with modified weighting to limit the dominance by individual constituents. In the case of bond indices, there is additional discipline imposed by credit ratings. If the index is weighted by outstanding debt, the threat of downgrade (and hence ejection from the benchmark) may add to high interest rates to deter unsustainable borrowing. Examples of other types of benchmarks include equally-weighted benchmarks, indices that attempt to maximise the diversification of risk, or fundamental indices focusing on metrics such as sales, dividends, earnings or cashflow. Whether or not alternative index construction methods should prevail is debatable, but some do offer potential in the form of increased risk-adjusted performance in the long term.
An index may be less diversified than investors think. In the FTSE All-Share index the largest 20 of the 601 companies represented currently comprise 55 per cent of the total index by weight. Sector wise, extractive industries, such as mining and energy companies, account for more than a quarter of the benchmark index and financials another fifth.
Concentration in indices is a potential source of risk that becomes more pronounced at exactly the wrong times. For example, in the run-up to the 2001-02 market correction, technology had come to represent 35 per cent of the S&P 500 index, while ahead of the financial crisis in 2007 the financial sector represented a third or more in most developed market indices.
However, it is not all about risk. Awareness of sector bias in indices can also be useful. For instance, investments in Russia’s energy-dominated Micex or Australia’s ASX (exposure to gold and mining) allow investors to encapsulate their views on these sectors while the commodity-rich Brazilian Bovespa has served at times as a proxy for China’s growth trajectory.
Apart from differences in construction, indices differ in what they represent in relation to their country of domicile. Mining and energy certainly do not make more than a quarter of the UK economy.
However, the wide geographical spread offered by the FTSE 100 index, with just more than a fifth of its revenues generated in each of the Europe, the US and the UK, 16 per cent in emerging markets and the remaining 18 per cent elsewhere, is a good way of achieving international exposure.
This is achieved while avoiding explicit currency and some corporate governance risks. The S&P 500 index, with two thirds of revenues from the US, and the Euro Stoxx50 index, with 46 per cent European revenues, exhibit a more pronounced home bias. At early stages of development, emerging market equity indices tend to be dominated by privatisations and state-owned enterprises, often banks and resource companies, which may not provide the best exposure to the more profitable parts of the economy.
Although the increased popularity of index investing notionally adds liquidity at the index level, this may not be reflected in increased cash market volumes or liquidity, as many index tracking instruments are constructed using derivatives rather than the underlying securities. For investors where liquidity is an important factor, this encourages more investment in indices and can be detrimental to the cash markets. Index investing also lends itself to risk-on/risk-off trades rather than a fundamental approach that looks at individual securities.
As this approach prevails, securities within an index and baskets of indices tend to move in concert. Correlations rise within and between indices and the diversification potential from investing in a ready-made portfolio diminishes.
Frances Hudson is global thematic strategist at Standard Life Investments
