Building Benchmarks

S&P500, Dow Jones Industrial Average, and the Nasdaq 100 are all household names to investors. However, many investors may not know what goes into constructing an index. Nasdaq’s Director of Index Product Development, Rob Jankiewicz joins Jeff Praissman to discuss how indexes are constructed and the many parameters that are used.

Summary – IBKR Podcasts Ep. 261

Hi everyone. This is Jeff Praissman with the Interactive Brokers Podcast. It’s my pleasure to welcome back to our podcast studio Rob Jankiewicz. He is the Director of Index Product Development at Nasdaq®. Hey, Rob, how are you?

Rob Jankiewicz

Hey, Jeff. Yeah, thanks for having me on again.

Jeff Praissman

I love having you guys come in for our monthly podcast together. We always cover a lot of great items—sometimes in the economic world, sometimes in the index world, the exchange world. And today’s going to be a really cool subject. We touched on some of the things we talked about last month—where’s a company, what makes a company a U.S. company? This is a little bit different, but we touched on some of these bases. Today we’re going to talk about index construction. And I want to start off asking what could be a simple question, but maybe not a simple answer, right?

What is the difference between an index and an index fund?

Rob Jankiewicz

Yeah. No, I think this is a great question to start with. Because although the term “index” sounds very similar to “index fund,” it is, in fact, different. At a very basic level, an index is basically a paper portfolio, whereas an index tracking fund—whether that’s an ETF or a mutual fund—represents actual investments. But in both cases, we can think of indexes or index funds as really a collection or basket of underlying components. And in the context of investing, those components are usually financial securities such as common stocks.

One thing I’ll note is that an individual or an investor cannot invest directly into an index, but they can invest directly into an index fund, which is tracking an index. So, because an index doesn’t actually trade, it doesn’t incur management fees. Index returns are considered frictionless and represent hypothetical performance before costs.

Jeff Praissman

Got it. Makes sense because it’s just all on paper, but yet there’s no exchange fees, there’s no commissions or anything like that. So, another term people hear is “passive” and “active.” So how does a passive fund differ from an active fund?

Rob Jankiewicz

Yeah, so there are some differences in how mutual funds or ETFs are managed. Now, typically, we consider funds as either actively or passively managed, and this just comes down to whether or not that fund is tracking an index.

A passive fund is designed to track its underlying benchmark as closely as possible, whereas an active fund intentionally tries to deviate away from that benchmark in order to try and outperform. So, in simple terms, a passive fund tries to track an index, whereas an active fund tries to outperform an index.

Jeff Praissman

Rob, this was great background—both just describing the difference between the index and index fund and then passive versus active. I want to now dive into our main subject. Indexes have investment objectives and methodologies, right? So the goal defines the goal of the index, and the methodology defines the rules used to construct it.

What are some of the key elements to the methodology?

Rob Jankiewicz

Yeah. So, there are typically a few major components that go into creating an index. It’s also important to point out that despite some differences across various indexes, all indices use some form of systematic, rules-based approach in constructing that final portfolio.

Now, after we define our objective or our goal, we’ll need to outline the steps that we’ll take to create that portfolio that meets the goal. To start, we’ll typically define eligibility criteria—or in other words, what are the rules that stocks have to pass to potentially get included into that index? And then once we have a selection or screening process in place, the index will define a weighting scheme to determine what is the allocation or the exposure to any underlying constituent in that portfolio. And the evaluation schedule, which helps to determine when we refresh that portfolio.

Jeff Praissman

So, for the universe of eligible assets, can it only be stocks, or can other assets like bonds or even options go into an index?

Rob Jankiewicz

Yeah, it really depends on the investment objective. For example, if the objective is to track U.S. equities, then the base universe might be limited to just common stocks listed in the United States. But there are also bond-based indices—such as the Bloomberg U.S. Aggregate Bond Index—or even options-based indexes, which hold options contracts to target specific outcomes.

Jeff Praissman

And for the components, some of the qualifications I can just think might be common sense—like maybe market cap, like large cap, small cap, mid cap—or liquidity. What about domicile? And again, we touched on this in our last podcast, but I think this is a great opportunity to maybe dig a little bit more into it.

Rob Jankiewicz

Yeah, in many cases there are different types of qualifications for the components that go into that index methodology. For instance, some indexes may define minimum market cap or liquidity screens. And in those cases, the securities that are from the base universe that don’t quite meet those market cap or liquidity cutoffs would not be eligible for the final portfolio.

And like you suggested, there might also be rules around country eligibility, in which case the index may screen stocks based off of country of domicile, country of incorporation, or even the country from which the security has the most revenue or asset exposure. But overall, each index is going to have some form of unique set of rules to best meet that investment objective.

Jeff Praissman

And I’d like to dig a little bit deeper into the weighting of indexes. Do all indexes use market capitalization as weights? Is it equally weighted? Are there different methods that indexes can use?

Rob Jankiewicz

Yeah. Good question. So, the short answer is that it can vary. If we take a step back for a second and just think about what part of the index methodology the weighting process comes into play—

Jeff Praissman

Right.

Rob Jankiewicz

It typically occurs after that final portfolio is selected. And weighting is important because it’s the part of the methodology that determines just how much exposure any individual component or constituent will receive in that final portfolio.

So many major indexes are based on market cap or float-adjusted market cap, but it can really vary across strategy or benchmark. Some indexes may follow an equal weighting scheme, in which case all index securities would receive the same exact weight. Or the weighting scheme can also be more involved.

For example, if the index is trying to target some form of factor exposure, then maybe constituents would be weighted based off of some fundamental metric or factor score. Or even in cases where the index is trying to optimize for something such as minimizing portfolio volatility, then in that case the index may be weighted based off of some sort of optimized weighting scheme.

Jeff Praissman

And Rob, there’s been a lot of talk regarding the Magnificent Seven stocks and their effect on the U.S. markets. What are some of the ways that indexes handle the changes in concentration—especially when some components increase in value at a significantly faster pace than others?

Rob Jankiewicz

Yeah, you’re absolutely right. So, concentration has certainly been a popular theme recently, and it’s also particularly important for market cap-weighted indexes—especially when you consider the size of those Magnificent Seven names, or those companies that you alluded to.

One way that indexes typically will handle concentration is by implementing what we’ll call weight caps. This is really just a constraint on the amount of exposure that any individual constituent can receive. For example, let’s say a single stock has an unconstrained or uncapped weight of 30%, but the index wants to implement a 20% cap. Then essentially, the index would trim down the weight of that stock to the cap and then redistribute that excess weight to remaining constituents in the basket.

Now, the last point I’ll mention around capping is that it’s really important for the regulated funds that are designed to track those underlying benchmarks. For example, in order for an investment fund to qualify as what we call a Regulated Investment Company—or RIC—the funds must meet certain diversification requirements on a quarterly basis. So, that’s really another major reason why indexes will implement this form of capping: to ensure that the funds designed to track those underlying benchmarks actually pass those diversification rules.

Jeff Praissman

And what are some of the ways that indexes measure concentration?

Rob Jankiewicz

Yeah, so I wouldn’t say that there’s one single way for measuring concentration. Many market participants like to focus on the weight of the top 10 holdings in a portfolio. For example, if you look up a fund fact sheet, generally the top holdings and their corresponding weights are highlighted. But given that some indexes have different numbers of constituents, it’s generally important to try and normalize for the size of the portfolio.

So just to add a little bit of color here—for example, the top 10 holdings of the Nasdaq-100 Index®, which has around 100 names, represent around 50% weight. Whereas the top 10 holdings of the S&P 500, which has around 500 constituents, represent around 36% weight. So this simple “top 10” approach may suggest that Nasdaq is more concentrated than the S&P 500, but that isn’t necessarily the case when you start to normalize for the number of index constituents.

Now, going beyond this “top 10 weight of the portfolio,” there are other techniques for measuring concentration—such as the Herfindahl-Hirschman Index, or HHI, which is typically used by regulators to measure market concentration. Or even index breadth, which is just another tool that tries to define the effective number of constituents in the portfolio, irrespective of the actual number of constituents. But overall, no matter the metric, each is really just trying to estimate how top-heavy the overall portfolio is.

Jeff Praissman

And all investments obviously have risk. One potential advantage of indexes is that diversification of risk. How do the indexes offset risk for investors?

Rob Jankiewicz

Exactly, yeah. So at a basic level, holding a single security is generally more risky than holding a basket or a portfolio of securities. And the reason for this is that any two stocks—or assets in general—are rarely moving in the same exact direction or the same exact magnitude at the same exact time. So, measuring the correlation of those returns helps us to understand the similarities and differences across the risk and return profiles of different securities.

If stocks are perfectly correlated—which really just means that they move exactly in sync—then there isn’t really much benefit of diversification when combining those two stocks together in a single portfolio. If we combine stocks that are less than perfectly correlated with one another, or uncorrelated, or even negatively correlated, then the portfolio’s overall risk may end up being less than the risk of any individual constituent. So overall, indexes generally offer diversification benefits by blending multiple securities together into a portfolio to reduce risk without necessarily sacrificing the potential return.

Jeff Praissman

And what about portfolio risk though? What are the components of portfolio risk?

Rob Jankiewicz

So the textbook answer is that there are typically two major components of portfolio risk. There’s diversifiable and non-diversifiable risk. And the idea is that only certain types of risks can be diversified away in the portfolio.

For example, a diversifiable risk—which is also known as unsystematic or idiosyncratic risk—usually tends to be company-specific. So, for example, if a company misses on earnings or makes some form of announcement that’s specific to that company—such as a company executive departing or some other major event—this will generally have a direct and immediate impact on just that company’s value.

However, non-diversifiable risks—so this is the other type of portfolio risk—we sometimes call this systematic risk. This is generally related to the broader market. For example, events such as a global recession or global monetary policy decisions—these types of events tend to have some type of impact on all companies, regardless of that company’s size or sector.

Jeff Praissman

And Rob, if you could leave our listeners with one broad statement on the advantages of indexes, what would it be?

Rob Jankiewicz

Yeah, absolutely. So, the short answer—I’ll give a short answer and a slightly longer answer. The short answer is that indexes are very important for investors.

But going into the more detailed or thorough answer: although not all indexes are built the same exact way, they all provide some form of systematic and transparent, rules-based way to measure the portfolio or the performance of a specific market or underlying constituents in a portfolio. So overall, those indexes are helping investors measure the performance of both active and index funds. Overall, indexes are pretty vital in the way that they help investors save and generate wealth over the long term.

Jeff Praissman

And Rob, it’s been my pleasure to have you on our podcast for a monthly podcast with Nasdaq. For our listeners, that was Rob Jankiewicz—he’s the Director of Index Product Development at Nasdaq. You can find lots of great content from Nasdaq on our website—both webinars and podcasts. Go to ibkr.com, click on “Education,” then click on “Podcasts” or “Webinars.” Even look for a contributor.

Until next time, Rob, that’s it for IBKR Podcasts.