Building a better benchmark for investment

Retail and institutional investors are continually evolving their investment strategies. Increasingly popular themes such as sustainability, and planning for future goals or retirement, impact the way we invest.

Catherine Yoshimoto is Director, Product Management at FTSE Russell

This means that benchmarks - the way that we can measure risk, asset allocation and returns of our portfolios – play an important role in every step of the investment process.

Many investors use benchmarks to conduct risk analysis and to develop investment policies and strategies. And once these strategies are implemented, nearly all investors use benchmarks to evaluate the performance of their portfolios. Benchmarks also underlie trillions of dollars in passive investment products such as mutual funds or Exchange Traded Funds (ETFs).

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To effectively serve these purposes, there are some universal design standards that every market-leading benchmark should follow: objectivity, modularity, and reliability. Adhering to these principles is essential to a benchmark’s ability to represent a market or market segment — and ignoring them can compromise the very essence of what benchmarks are intended to do.

For a benchmark to deliver an unbiased, complete view of the market it’s designed to represent, it’s important that index providers, such as FTSE Russell, select its constituents with objectivity.

This means the index should be constructed with a disciplined, systematic approach that doesn’t require any specialist knowledge of the market or its constituents.

All benchmarks aren’t equal in this regard. Differing approaches to constituent selection can have a significant impact on benchmark composition. For example, funds or ETFs based on an index can tilt the weighting of companies based on preferred factors, such as climate/sustainability themes or sectors.

Unsurprisingly, these differences in coverage can have a significant impact on the performance of the respective benchmarks — particularly when it comes to some tech and innovation companies with rapidly growing market capitalisations.

A second important benchmark construction principle is modularity. By this we mean that the broad market index is segmented into modular components — or building blocks — that investors can use separately or in combination to build a portfolio that best fits their objectives.

For example, the FTSE UK Index Series is segmented based on the market capitalisation of a company. The FTSE 100 Index comprises the 100 most highly capitalised eligible companies listed on the London Stock Exchange while the FTSE 250 Index comprises mid-capitalised companies not included in the FTSE 100. The FTSE All-Share Index - representing 98-99 per cent of UK market capitalisation, is the aggregation of the FTSE 100, FTSE 250 and FTSE Small Cap Indexes.

A lack of modularity can produce inadvertent exposures and undermine the intended asset allocation goal. For example, if the lines between small and large cap market segments are blurred, an investor using separate indexes to allocate assets between the two categories may end up with overlap.

It’s critical for an index to have a disciplined, reliable and transparent methodology in place that’s backed by a well-defined, balanced governance system. The market is constantly changing as new companies are listed, existing firms are acquired, and companies grow to reach new size segments.

To ensure we’re staying abreast of these changes, FTSE Russell employs a regularly scheduled series of objective maintenance processes that not only includes regular reconstitution and rebalancing, but also additions of IPOs that become eligible for index inclusion and as-needed adjustments due to corporate actions. Indexes that lack the maintenance protocols necessary to reflect market changes in a timely manner may lead to unintended bias to particular sectors or company size, and may not reflect the market it is intended to represent.

A benchmark is only useful to the extent that it accurately reflects the market or segment it’s intended to represent. Ensuring exposure to the true opportunity set allows investors to make informed decisions to build their preferred investment strategies, helping them balance risk and allocate their assets. Through well designed benchmarks, investors are provided with the tools to track their investments, and ensure that exposure is aligned with intended strategies.

For more information and insights on benchmarks, please visit FTSE Russell’s website.