If it makes money, measure it

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If it moves in a market, there is an index for it. Over the past five years, the number and range of indices launched as tools for investors have boomed.

From ethical investment to arcane credit derivatives, indices are providing ever more specialised benchmarks against which investors can measure performance.

Indices used to be fairly straightforward. Typically benchmarks of equity markets, they provided investors with a gauge of how well or badly things were going.

But as investors have expanded their investing horizons, so has the range of indices broadened. As many institutional investors tailor their investment strategies more closely to their objectives, there has been a wave of customisation of indices.

In addition, the boom in exchange-traded funds – listed investment vehicles that track a benchmark or an asset – has opened up new areas of index-linked investing.

Mark Makepeace, chief executive of FTSE Group, says: “The benchmarking industry has changed significantly over the past five years. The big players may be the same – FTSE, MSCI and S&P – but the quality and range of indices offered by them have increased dramatically and the way they do business today bears little resemblance to previous times.”

FTSE, which is 50 per cent owned by the Financial Times, calculates more than 120,000 indices a day. It says some 30,000 are customised equity indices produced for investment managers seeking a specific benchmark for their needs. FTSE says some $3,000bn of assets are managed against its benchmark.

MSCI Barra, FTSE’s rival, says it calculates more than 130,000 indices a day and some $3,500bn of assets are using them as a gauge.

Dimitris Melas, executive director and head of research in Europe, Middle East and Africa for MSCI Barra, says: “We have definitely seen a big increase in recent years in the range of indices on offer to investors.” He adds that the growth of ETFs has been a key driver in this process.

ETFs are now available for investors to take a view on markets ranging across asset classes, geographies and niche areas – everything from US healthcare stocks to nanotechnology shares to the Belgian stock market. Most track an index.

Morgan Stanley estimates there were some 847 ETFs round the globe by the end of the first quarter, and it forecasts another 543 will be launched before year end. The investment bank predicts global ETF assets under management will reach $2,000bn by 2011 from the current $604.2bn.

One of the biggest changes brought by ETFs has been the promotion of “fundamental indices”. These eschew the traditional basis of most stock market ETFs – indices such as the S&P 500 that reflect shifts in share prices and market capitalisation.

Instead, they are based on indices of stocks centred on so-called fundamental factors, such as earnings, dividends and the book value of companies. They aspire to avoid the distortions and pricing anomalies arising out of market cap indices. Supporters claim that markets are not always priced efficiently and the top 10 stocks in an index are not necessarily the most attractively valued.

The fundamental ETFs have opened a debate about the nature of indices and how they should be used.

They have won influential support. Powershares’ FTSE RAFI products are backed by Rob Arnott, the editor of the Financial Analysts Journal. Powershares’ rival WisdomTree is supported by Jeremy Siegel, Wharton School professor and author of Stocks for the Long Run.

The theory is that an extra layer of stock selection can add to superior returns. Mr Arnott says backtesting of a composite of the RAFI indices showed an excess of returns over a market cap benchmark of 2 per cent a year since 1962.

Growth has also been driven by bigger investors, such as pension funds, seeking specific benchmarks.

“Benchmarks still perform the same function – assisting the investor in forming their asset allocation strategy, setting the boundaries for the portfolio and evaluating the performance of the fund manager,” says Mr Makepeace.

“The difference is that the index provider will now customise products to meet the fund’s exact mandate requirements, enabling the request of any type of benchmark excluding or including a selection of economic sectors or particular stocks,”
he says.

There has also been growth in indices for investment areas that are often illiquid and difficult to measure, such as hedge funds and property.

Mr Makepeace says another growth trend could be multi-asset customised benchmarks.

“Currently, bond indices are proprietary products, calculated by the investment banks. As the price sources improve and better prices become available, public index providers will challenge these, and be able to integrate them with equities and other asset classes to bring truly multi-asset customised products to meet specific mandates,” he says.

Mr Melas says with more shares changing hands privately, how representative of the value of markets will the traditional indices be?

Deals that occur on private inter-bank platforms – known as “dark pools of liquidity” – probably ac­counted for about 10 per cent of share trading in the US last year, a sharp increase from previous years, according to research by the Tabb consultancy.

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