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Navigating the Maze of Index Strategies

Index investing through exchange-traded products (ETPs) continues to gain momentum in all asset classes. Despite a global economic downturn in 2008, the pace of new issuance in exchange-traded funds (ETFs) and exchange-traded notes (ETNs) continued. US exchanges added 221 new products that track a variety of new and exotic indexes. Over 500 new funds are in SEC registration as of early 2009, and growth is on track to reach 1,000 ETPs on the market by 2010. New companies entering the marketplace include PIMCO, Charles Schwab and JP Morgan.

New index strategies are unlike traditional indexes that use passive security selection and capitalization weighting. Today, many new indexes use qualitative and quantitative strategies that by default imply active management techniques. Nonetheless, these complex index methods satisfy certain requirements established by the Securities and Exchange Commission to register a new product as an index fund or ETP.

Index Categorization

Unfortunately, the tools needed by investors to analyze new index products have not kept pace with advances in methodology. Most categorization methods classify products by style such as value versus growth for equity funds and investment-grade versus non-investment grade for bonds funds. That is fine at one level, but it does not explain how an index provider selects securities or manages securities.  A new index categorization method introduced in this article approaches the issue from a different perspective by sorting products by index rules rather than investment style.

There are two levels to index rule categorization. At the first level, indexes are separated into two types; benchmark indexes and strategy indexes. A benchmark index is a yardstick that measures total market value while a strategy index is any alternative way to invest in a market. At the second level, investment products can be sorted into nine Index Strategy Boxes™ based on the index rules that those products follow. The boxes help an investor understand the basic security selection and weighting rules governing an index so they can better understanding how a fund that tracks that index is managed.

Benchmark indexes are market valuation tools. They are constructed to measure and compare various financial markets and segments of those markets. Index constituents are selected using passive methods to capture a broad cross-section of securities and those securities are then capitalization weighted in the index. Benchmark indexes are used in global finance for return comparisons and used at the highest level in banking and as economic indicators. They are the ’Beta’ of the market in the Capital Asset Pricing Model (CAPM). In addition, investment consultants and advisors use benchmarks as the basis for asset allocation decisions. Finally, a benchmark index represents a passive opportunity set from which all active investors select from, and those indexes are yardsticks by which active management strategies are measured against.

Strategies indexes are alternative methods for investing in the financial markets. Much like active management, their purpose is not to represent a market return. Strategy indexes do not measure Beta, nor are they used as a substitute for Beta. Rather, strategy indexes are designed to intentionally capture a return path that differs from a benchmark index. Strategy indexes are engineered primarily as the basis for investment products. The index provider typically selects securities using other than passive methods, or weights securities using other than market capitalization, or both. Like active management, strategy indexes tend to have a higher turnover than benchmark indexes. 

Index Strategy Boxes™ 

Index strategy has expanded into complex methods and the tools available for analysis must advance to the same level. Index Strategy Boxes address this issue. The classification method divides all index strategies into nine distinct categories based on published indexing rules. This provides a framework for differentiating one index strategy from another and helps investors compare and contrast various index products.

The construction and maintenance for every index is published by the index provider as a set of rules. Those rules are typically accessible to the public through an index methodology handbook that can be viewed on a provider’s website. Not all index providers are as forthcoming with their methods; however, there is generally enough information available to categorize index products by their published rules.

Index Strategy Boxes were created as a way to visualize the index strategy that index funds and ETPs attempt to track. The classification system helps investors quickly grasp an understanding of how a product’s underlying index strategy differs from benchmark methodology, and how two products differentiate from each other. For example, Index Strategy Boxes can be used to sort and compare the performance and fees of funds that follow similar rules.

The Security Selection Axis and Security Weighting Axis

Index Strategy Boxes sort funds based on two criteria; security selection rules and security weighting rules. Those two dimensions are placed on a vertical and horizontal axis forming the nine Index Strategy Boxes. The figure to the right illustrates the tic-tac-toe design. The boxes further divide index products into three primary security selection rule types and three primary security weighting rule types. These nine selection and weighting categories apply to all assets including stocks, bonds, commodities and currencies. Every index product falls into one of the nine boxes.

The Security Selection Axis

The vertical axis in the diagram classifies the Security Selection process. Each row represents a primary strategy used to select index constituents from the financial markets. The three broad selection categories are passive, screened and quantitative. Indexes that fall into a broad category can have one or several security selection methods as shown in Table 1. The methods shown are examples, they are not absolutes.

Table 1 – Three Security Selection Categories and Examples of Methods

Passive Selection Screened Selection Quantitative Selection
 - Full Replication - Fundamentals - Economic Cycles
 - Sampling Strategies - Thematic - Forward Estimates
 - Buy & Hold - Single Exchange - Momentum /Technical
 - Single Securities - Niche Industry - Black Box

Passive Selection: Indexes using passive security selection attempt to generally represent the securities in a broad market or a segment of that market. Some indexes use a large number of securities and other sample securities with the intent of representing the broad market or segment of the market. Industry sector, size and style funds fall under this category when they are direct sub-sets of broad market indexes. For example, the Russell 2000 value index is a subset of the Russell 3000. Passive selection also includes single securities such as a currency, commodity, or an ounce of gold.

Screened Selection: Indexes created using filters to sift through a broad list of securities and eliminating unwanted issues. The filters can eliminate securities for many reasons depending on the desire of the index provider. Once the unwanted securities are screened out, the remaining securities become the index. For example, companies could be eliminated if they lack certain fundamental factors such as dividends, or are deemed not to be social conscious or environmentally friendly. One popular screened index is the NASDAQ-100. It is a listing of only large NASDAQ stocks and excludes all financial stocks. Powershares QQQ Trust 1 ETF (ticker: QQQQ) tracks the NASDAQ-100 index.

Quantitative SelectionIndexes using computer modeling to isolate a small number of potentially superior investments. The intent of the creators of the quantitative indexes is to compile a concentrated basket of securities that offer superior potential returns compared to a benchmark. Quantitative index providers tend to be vague about their methodologies for fear their strategy will be compromised. ETFs that use quantitative selection strategies have a much higher securities turnover rate than ETFs following passive or screened indexes, and the expense ratios tend to be much higher.

The Security Weighting Axis

After constituents are selected for an index, the index provider applies a weighting methodology to the index. The three basic weighting methods are represented by the Security Weighting classification. The weighting factor used in a benchmark index is capitalization whereby a securities percentage weight is in proportion to the total market value of all securities in the index. Some, but not all strategy indexes use alternative weighting methods other than capitalization.

The horizontal axis of the Index Strategy Box classifies weighting methodologies into the three broad weighting categories: capitalization, fundamental and fixed weight shown in Table 2. The methods listed under the categories are not all-inclusive.

Table 2 – Security Weighting Categories and Select Methods

Capitalization Weight Fundamental Weight Fixed Weight
 - Full Cap  - Financial Factors  - Equal Weight
 - Free Float  - Dividend Level  - Modified Equal
 - Constrained  - Security Price  - Leveraged
 - Liquidity  - Momentum  - Short (inverse)
 - Production  - Qualitative Factors  - Long/Short  130/30

Capitalization weight: Securities are allocated based on the market value of each security in proportion to the total market capitalization of all securities in the index. Capitalization weighting is the standard method for benchmark indexes worldwide. There are different types of capitulation weighting. Some of those types do lead to small difference in long-term return, but not market enough to make a meaningful difference. In the U.S. alone, there are thousands of capitalization weighted indexes covering all corners of the financial markets.

Fundamental weight:  Security weighting relies on a variable factor or factors other than market capitalization. Weighting may be based on financial data such as dividend yield, earnings or revenue, or it may be based or a multi-factor weighting model that combines financial factors. Fundamental weighting can also be applied to non-financial data such as a price momentum or a qualitative ranking such as ‘best in class.’ Regular reweighting through quarterly or annual rebalancing is needed to keep the constituent weights in line with the variable factors.

Fixed weight:  Indexes using a flat or fixed allocation method to assigned constituent weights. Fixed weight strategies can occur on three levels; the security level, the industry level, and the Beta level. Simple examples are an equal weight index where all securities are assigned that same percentage, the equal weighting of industry sectors, and leveraged, inverse, and other long-short Beta strategies. There are many variations to the above types. For example, modified equal weighting refers to using fixed allocation tiers so that some securities receive a higher fixed allocation than others. Regular rebalancing is needed to keep fixed weight indexes in line.

Different index weighting methods leads to different performance paths. Fundamental weighting using financial data generally overweighs value stocks relative to benchmarks and tends to perform best when value stocks outperform growth stocks. A fixed weight stock index using equal weighting brings the average market capitalization of an index below the benchmark. This implies fixed weight methods will outperform capitalization weighting when small cap stocks outperform large cap stocks.

Using Index Strategy Boxes

Index Strategy Boxes help investors quickly and easily identify differences in index methodologies and pinpoint desired investment products. That is useful to every investor and every fund provider. Learning the system requires some thought, but once understood the method becomes intuitive and very helpful.

Finding detailed information about index construction rules can be difficult because some index providers are vague in their disclosure. In addition, there is little standardization of the terminology; for example, modified-equal weight strategy by one index provider may mean something completely different by another. Fortunately, much of the work is being done for you. Index Strategy Box information on all ETPs is part of a free on-line database at

The ETF Book and the Index Strategy Box Database

The ETF Book by this author covers index construction and classification methods in greater detail. It provides background information on the evolution of ETPs including SEC regulation, various operating structures, and index methodology. The book also expands on the concept of index classification methods. The ETF Book and the free ETF database at are part of a growing body of knowledge that helps investors understand index based products and in turn make better investment decisions.