The Index Matrix is a useful concept first developed by Rick Ferri.
Index rules tend to be similar enough across index providers so that a broad-based categorising and organising system of those rules can be created.
The rules for index construction generally fall into two broad categories:
A. Security Selection and such constituent selection Review and
B. Security Weighting and the Weights Rebalance.
How securities are selected is the first step in index construction. How those selected securities are weighted in the index is the second step.
The two categories of security selection and security weighting are the two dimensions of Index Strategy Boxes, in the top right corner of each product field, we list the Constituent Review Frequency, while in the bottom right corner we list the weight Rebalance Frequency.
The Security Selection Axis
On the vertical axis of the Matrix you will find the Security Selection columns, that confines the methodologies used to select securities for the underlying ETP index, into tree broadly defined selection methods namely Passive, Screened, and Quantitative.
The first category Passive selection seek just to replicates the defined investment universe. Many passive indexes for practical reasons, do not hold all the securities that trade within the universe, although it is the intent of the index provider to represent the broad market. Passive indexes typically hold just enough securities so that the basket has similar risk and return characteristics in relation to the market as a whole. Likewise, many ETPs do not hold all the securities that compose the underlying index, although it is the intent of the ETP provider to track the index as closely as possible.
There are typically few requirements for a security to be a member of a passive index. Those requirements typically include a minimum number of shares outstanding, a certain minimum daily trading volume, and a minimum market capitalization. The constraints placed on some passively selected indexes will not materially affect the performance of the index relative to a complete broad market index.
There are different types of passive selection used by index providers and ETP managers. They include completion methods, sampling and optimization methods, and the use of derivatives, such as options, futures, and especially swaps. The premise behind all security selection is that the composite portfolio replicates the price movement of a broad market of securities, regardless of the underlying method used to replicate those returns.
The second type of security selection is screening.
Screening securities filter unwanted issues out from an Index. The screening process starts with a broad market universe of securities and then filter out those that do not meet certain criteria. Screening goes a step beyond the requirements for a simple passively selected index by isolating securities according to one or several factors.
A Dividend screens is an example of such a filter. Here companies that do not pay a regular quarterly dividend are filtered out. A second filter could be added to ensure a company has paid dividends for at least three years. A third screen could be put in place that ensures a company has not cut its dividend in the past five years. The remaining securities represent the basket of stocks that meet the index provider’s specifications.
Screens can be applied for social or religious reasons. In a socially responsible stock index, companies that are believed to be in a socially harmful business or follow socially unacceptable business practices are eliminated. Undesirable companies that are often screened out are in the tobacco, alcohol, and gaming industries. After screening for social issues, the result is a basket of supposedly responsible companies.
The third type of security selection is quantitative. Securities in a quantitative index are selected on the basis of advanced computer models that follow complex mathematical formulas. These models are often referred to as black boxes because those on the outside are not supposed to know how the models work.
Quant index providers program their software to isolate what they believe is predictive information in securities data and prices. The idea is to separate potentially market-beating securities from potentially market-losing securities. Such detailed selection rules of most quantitative models are often proprietary and not made available to the public except on a very general basis. It is often argues that the full transparency behind the previous two types of selection methodologies can actually be a source to loss of returns for fund investors, since some institutions specialise in front running the index changes
The Security Weight Axis
Once securities are selected for an index, they need to be given a weight in the index. The horizontal axes of the matrix classify weighting methodologies using three basic methods, which are Capitalization Weight, Fundamental Weight, and Fixed Weight. Weighting methods are important because the fundamental characteristics of a given basket of securities change when using each of the three different methods.
Market Capitalization weighting is the traditional method for constructing market indexes. Securities in a market index are allocated on the basis of the market value of each security in relation to all of the other securities in the index. There are four basic methods of capitalization weighting used by index providers. They are:
Full Market Cap
Free-Float Market Cap
The difference between full cap and free float is that the former includes the entire value of securities in the index while the latter includes only the value of shares that are available in the public markets.
Unlike full or free-float indexes, liquidity weighting is based on the actual value of securities that trade on a market. Although there may be a large number of shares that could trade based on a securities float, it is the market value of the trades that is the most important component for ETP companies and authorised participants. Liquidity weighting is a particularly useful method of managing index ETPs in hard-to-trade foreign markets.
The second type of weighting methodology uses fundamental factors.
A fundamental weighted index relies on one or several factors other than market capitalization to weight stocks in an index. Information that may be used includes financial factors such as earnings or a combination of accounting measures. Another example of a weighting factor can be stock dividend yield, where the greater the dividend yield of an index constituent, the greater that stock’s weighting in the index. Since fundamentals change over time, fundamental weighted indexes are rebalanced periodically to realign the index with current conditions.
The third weighting category represents fixed weight strategies. There are five basic types:
An equal weight allocation assigns the same percentage to every security. For example, in a 100 bond index, each bond is weighted to 1 percent of the index. Modified equal weights are used to allocate securities among two or more fixed percentages based on some method of priority. Larger stocks might be weighted 2 percent, whereas small stocks might get only 1 percent. Securities can also receive a fixed weight based on a ranking system using quantitative methods. For example, securities in the top quintile group might be allocated 2 percent each and securities in the second quintile group might be 1 percent. The weightings in fixed weight indexes are generally rebalanced regularly.
One can think of Passive - Capatalization Weighted indexes as a purist proxy for the performance of a given investment universe. While other more customised indexes are set apart from market indexes by their security selection and security weighting methods.
With few exceptions, it is the intent of the customised index provider to deviate from the characteristics of a market index. The providers intentionally seek a different risk and return path than that provided by the market, which can also be argued is a form of active management.