Index investing through exchange-traded funds (ETFs) is booming. Indexed assets already exceed 10 percent of the value of the U.S. equity market and by the end of 2008, there may likely be over 1,500 index products available. Unfortunately, investors and advisors have become overwhelmed with different index options available. It is difficult at best to keep up with the new products that follow the new indexing strategies.

Gone are the days when indexes existed solely to measure market value. Today, many new indexes are highly customized investment strategies that are designed to be investment products rather than market indicators. These index strategies are often complex, and categorizing them has moved beyond standard-style classification methods such as Morningstar Style Boxes™. What was needed, and what this paper explains, is a complementary classification system that differentiates indexing methodologies based on their published rules for security selection and security weighting.

The index categorization methodology briefly introduced in this paper is a new way to look at the marketplace. The classification method has two stages. The first step defines the purpose of an index, and the second defines the index strategy using a new tool called Index Strategy Boxes™. Incorporating these two stages will greatly reduce the time needed to analyze index-based products by quickly identifying how an index is constructed and maintained.

Market Indexes and Custom Indexes
The first step in the analysis is separating indexes by purpose. There is a significant difference between traditional market indexes and highly customized strategy indexes.

Market indexes are market measurement tools. Their primary purpose is to measure the general price level and value of financial markets and segments of those markets. Constituents in a market index are commonly selected using passive methods, and they are capitalization weighted. Market indexes have always been important financial indicators as global valuation yardsticks. They are reviewed and analyzed at the highest levels of economic analysis, including all central banks. In addition, market indexes are the basis for asset allocation decisions, whether those decisions are being made by individual investors or institutions. Finally, market indexes are the benchmark against which all active investments strategies are measured.

Many new indexes are highly customized investment strategies that are far from market measurement tools. In fact, these indexes are intentionally designed not to mirror the price action and performance of market indexes. The creation of strategy indexes are primarily driven by the needs of the product manufacturers. Basically, custom strategy indexes are licensed to investment companies and launched as innovative investment products that compete against market index products. It is worth noting that products following custom index strategies generally have higher fees than products that follow market indexes.

Index Strategy Boxes
The rules for the construction and maintenance of any index are published by the index provider and are available to the public. Typically the index methodology can be found in a handbook located on the index provider’s website. However, it is worth noting that some index providers offer more transparency than others, and some only provide the bare minimum as required by the Securities and Exchange Commission (SEC).

Index Strategy Boxes™ categorize published rules and add order to the marketplace. That helps investors visualize how an index is "managed" and allows them to anticipate what should be taking place in the funds they are analyzing. The classification method focuses on two rule types: security selection methodology and security weighting methodology. All indexes have set rules for security selection and set rules for weighing the securities that are selected. Those two rules' axis applies to indexes including stocks, bonds, commodities and currencies.

Index Strategy Boxes™ divide funds by three primary types of security selection and three primary types of security weighting. The two dimensions can be illustrated on vertical and horizontal axes, which form nine Index Strategy Boxes™. Figure 1 illustrates the tic-tac-toe design of Index Strategy Boxes™. Every index falls into one of the boxes.

Figure 1

The Security Selection Axis
The vertical axis of the Index Strategy Box™ diagram is Security Selection. Each row represents a primary strategy used to select index constituents from the financial markets. The categories are passive, screened and quantitative. Indexes that fall into each category typically have one of the security selection methods found in Table 1.

Table 1 – Sample Security Selection Categories and Methods

Source: Portfolio Solutions, LLC

Passive security selection replicates a broad market or a segment of that market. Many passive indexes sample securities with the intent of representing a broad market or segment of the market. Single securities also can be thought of as passive indexes in that they represent the price movement of one item; i.e., a single currency or an ounce of gold.

Screened indexes filter through lists of securities, with the intent of weeding out unwanted issues. Screening starts with a broad market universe of securities and then eliminates those that do not meet certain criteria. Screens may include fundamental factors such as dividends, social issues, environmental issues, niche industry, single-exchange preference such as QQQQ, and a variety of other factors.

Quantitative security selection relies on computer modeling to isolate a small number of potentially superior investments. The intent of quantitative selection is to identify a basket of securities that are believed to offer better returns in the future than a comparable market index. Quantitative selection strategies have much higher turnover than passive or screened indexes. Several quantitative index providers hold their selection methodologies close for fear that their strategies will be compromised.

The Security Weighting Axis
Once securities are selected for an index, they need to be given a weight in the index. Investors need to be aware of how weighting schemes affect an index. Different weighting methods can radically change the fundamental characteristics of a securities basket, and that will have an effect on performance over a market cycle.

The horizontal axis of Index Strategy Boxes™ classifies weighting methodologies into three categories: capitalization, fundamental and fixed weight. Examples of weighting categories and methodologies are shown in Table 2.

Table 2 – Sampled Security Weighting Categories and Methods

Source: Portfolio Solutions, LLC

Index providers allocate securities using one of the three basic methods. A capitalization-weighted index allocates each security based on its relative market value compared to all other securities in that index. A fundamentally weighted index uses financial data or qualitative factors to allocate among index constituencies. Fixed weighting assigns a set weight to each security in an index or sectors within the index. Leverage, short, and long-short funds are also considered fixed-weighted indexes because the entire index value is changed by a fixed amount.

Securities in a capitalization-weighted index are allocated based on the market value of each security relative to all other securities in the index. Capitalization weighting is the standard method for security weighting worldwide. In the U.S. alone, there are hundreds of capitalization-weighted stock indexes covering all corners of the financial markets.

A fundamentally weighted index relies on a single factor or set of factors other than market capitalization to weight stocks. Weighting may be based on financial data such as dividends, earnings and earnings predictions, or it may be based on price momentum, company qualitative rankings or a multifactor weighting method that combines several items. Regular rebalancing is needed to keep the weightings in line.

Fixed-weighted indexes have a fixed allocation for each constituent in an index or groups of securities in an index. There are several types of fixed weights, including equal weighting, modified equal weighting using several fixed levels, and equal weighting of segments or industries. Indexes using leveraged, inverse, and long-short strategies are included here. Those strategies magnify changes in the entire market by a fixed amount. Regular rebalancing is needed to keep the weightings in line.

Using Index Strategy Boxes
Index Strategy Boxes™ data can help investors quickly and easily identify index strategies and pinpoint appropriate investment products. When using the system, it is assumed that an investor has already decided on a particular style of investing (fixed income, equity value, equity growth, small cap, etc.). The first step in index analysis is deciding if it is more advantageous to use a low-fee product that follows a market index or a higher-fee product that follows a custom index. The second step is analyzing index strategies more closely by using Index Strategy Box™ methodology, as well as other means.

Unfortunately, finding detailed information about indexes is often difficult. The information provided by index providers can be vague and ambiguous. In addition, there is little standardization of terminology. What is called a modified-equal weighting strategy by one provider may be called something different by another. To make matters worse, some providers claim their indexing methods are proprietary and release little relevant information on index construction.

Fortunately, efforts by advisors and investment managers are starting to yield results. Index providers are starting to share more information, and analysts are digging more deeply into index construction and its implications for ETF investments. It is hoped that Index Strategy Boxes™ can contribute to the greater flow of information, which will lead to better-informed decision making.

To learn more about index construction for ETFs
For investors and advisors who wish to learn more about which types of indexes are being tracked by which ETFs, much of the grunt work is being done for you. Index Strategy Box™ information for all ETFs is available at www.ETFguide.com.

Richard Ferri, CFA, is founder and CEO of Portfolio Solutions, LLC. The firm manages $1 billion in index funds and ETFs for private investors using strategic asset allocation methods. Ferri is a frequent speaker and writer on index funds, ETFs and asset allocation. A detailed discussion of his index classification methodology discussed in this paper is at www.PortfolioSolutions.com and The ETF Book [Wiley - December 2007].