Each index provider creates their own set of requirements to define an index universe. As for equity ETFs, some of the key differences between the methodologies used for creating the indexes are: number of components, market, capitalization, sector style, and composition. For fixed income ETFs, the providers create indices around criteria such as credit quality and maturity. Understanding differences like these can help ensure that portfolios contain the right ETF for a client’s investment needs.

In many cases, there is no right or wrong index to use. Five criteria need to be considered:

 

  • Comprehensiveness

    Does the index (or the ETF) accurately reflect the existing set of investment opportunities? The ideal index would include each and every one of the titles in their respective asset class. However, it becomes necessary to adopt a compromise between the breadth of market coverage and the investment capacity of the stocks that make up an index. In the case of reference benchmarks that hold a lot of limited liquidity stocks, some optimization may be appropriate.

  • Rules of the index

    Are the rules that govern the components of the index transparent and public? Objective rules allow fund managers to predict, more or less accurately, what stocks will be added to an index or will be removed from it, thus allowing the fund to more accurately track the index.

  • Data

    Is the performance data for the index accurate, complete, and readily available? Access to reliable data allows fund managers to evaluate and compare indices both for a particular market sector and between different market sectors.

  • Acceptance by investors

    Are investors aware of the index and do they use it? A well-known and widely used index can be used to make comparisons with similar parameters, and should also provide a reliable reference criterion for long-term investors.

  • Turnover and related costs

    What is the turnover of the index? Are the rebalancing costs appropriate for the ETF? In general, the lower the turnover, the lower the rebalancing costs for the fund provider.

Well-prepared indices (or ETFs) will tend to easily meet most or even all of these criteria.