Selecting index securities
At its core, an index is only as useful as the securities it tracks—which means its constituent selection process is of the utmost importance.
Research shows what common sense suggests: Similar securities tend to exhibit similar performance characteristics. Thus, if you’re building an index, it only makes sense to group like securities together.
In the past, trawling through the hundreds of thousands of securities that made up the total market was such a Herculean task that all but the most narrowly-defined indices were built from the bottom up. That is to say, indexers built their indexes by picking out individual securities and adding them in.
But now that computers are commonplace, most market indexes are now constructed top down, meaning indexers first evaluate the full set of available securities and then select individual stocks accordingly, depending on finer and finer selection criteria.
Indexers can choose securities for index inclusion based on any number of shared characteristics:
- Asset class (equity, bond, commodities, etc.)
- Market cap size (large, small, micro, etc.)
- Industry or line of business, as defined by percentage of sales or revenues
- Regional or country focus, as defined by percentage of sales or revenues
- Dividends, earnings per share or other accounting factor, by percentage of stock price
- Any other grouping criteria
Securities can also be eliminated from inclusion according to a cut-off market, such as market cap minimum or a fixed percentage of a given market.
Each index company has its own security selection methodology, and investors should read up the fine print behind a benchmark’s process before purchasing any funds based on it.
Further Reading: When index funds can’t replicate their benchmarks
Market participants should take note that not all index funds can or will replicate their benchmarks exactly.
In the case of illiquid asset classes (emerging market bonds, for example), fund managers often can’t purchase the securities in the quantities needed to be representative without moving the underlying market. Or in the case of indices that track a large number of securities (e.g., total market bond funds), fund managers would incur prohibitively high costs to purchase the thousands of securities necessary to exactly reproduce the index.
In these cases, fund providers will be forced to employ sampling or optimization techniques to select some smaller representative set of securities instead. The goal is always to ensure the fund mimics the performance characteristics of its benchmark, but some optimization schemes end up working better than others.
Keep in mind that this “copy of a copy” approach to fund construction inevitably introduces some tracking error—known as sampling error—which can affect overall portfolio returns. So when investing in index funds that track illiquid assets or a large number of assets, as always it pays to read the fine print.