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What’s Inside Your Index?
By John Williams | 21 February, 2012

By contrast with benchmark indices, which usually select constituents by a simple measure like market capitalisation, strategy indices encapsulate a systematic investment process or algorithm within the selection and calculation methodology. Investment products (funds or notes) tracking such indices will usually gain economic exposure to the index via a swap (or option) obtained from an investment bank. Just as the calculation of a fund’s net asset value (NAV) per share will take into account purchases and sales of investments, as well as investment income, gains, losses and operating expenses, the calculation of a tradeable index will also include some measure of each of these components. The objective is that, as far as possible, what you see in the index is what you receive in the end-product.

It pays to look hard at possible layers of costs inside the underlying index before you select an index fund, ETF or structured product. Below we examine industry practice in managing strategy indices and point out what to look for and where to find information on costs.

Costs And Fees

Trading costs are an inescapable part of investing and indices designed to be tradeable usually make some adjustment for these costs. Typically an investor will not be able to match precisely the prices used in an index’s calculation. This, in turn, will result in some day-to-day tracking differences between the investor’s portfolio and the index. Over short time periods such effects are often small, but when the index is rebalanced this price difference is “locked in”, resulting in a permanent shortfall in the replicating portfolio when compared with its underlying index.

Tradeable indices attempt to minimise this shortfall by making a so-called “rebalancing adjustment”. Such adjustments can be as simple as taking into account the market bid/offer spread when buying or selling assets during the index rebalancing. In this way, the index is mirroring the costs that would be incurred by a fund undertaking the same operations. Where the bid/offer spread is not available or is unreliable, a common alternative is for the index to apply a fixed rebalancing cost, which captures transaction costs but also includes a margin to allow for expected price slippage (where the investor cannot trade at or close to the prices used in the index calculation).

In less liquid markets (for example, emerging market equities and bonds and, especially, in options markets) both slippage and bid/ask spreads can vary widely, particularly during periods of market stress. To accommodate this, some indices resort to relatively complex rules to calculate rebalancing costs. For example, the JP Morgan Macro Hedge strategy index tracked by an ETF the investment bank has recently launched in partnership with Source has a rebalancing charge of between 0.2 percent and 0.5 percent on each monthly futures “roll”. The level of this charge is set by the underlying VIX index, with 0.2 percent applying when the VIX is below 35, 0.5 percent when the VIX exceeds 70, and a sliding scale in between. The roll cost applies to both long and short positions in the index, implying that total roll-related expenses could approach or exceed 10 percent a year.

A high proportion of strategy or hedge fund indices used in listed investment products also take out a fixed fee from the investment return. This fee is used to pay for the management of the index hedge portfolio and may also include an index management fee. These fees are usually taken from the daily asset returns. For example, the JP Morgan Macro Hedge US TR Source ETF levies a flat index fee of 0.75 percent a year.

Where To Look For Index Fees

Index providers often have several different versions of an index. So, before anything else, note the exact index name and don’t assume that all indices in a family operate in the same way. For example, the iShares iBoxx Euro Corporate Bond fund (LSE: IBCX) tracks the iBoxx Euro Liquid Corporate Bond index from Markit. db X-trackers’ Euro Liquid Corporate 100 ETF (Deutsche Boerse: XBLC) tracks a similar index from the same provider. But while the iShares fund uses bid and offer prices on the underlying bonds to rebalance, the db X-trackers fund charges an “index replication cost” of 0.4 percent a year. These two cases illustrate the different approaches to rebalancing adjustments that we outlined earlier.

 

 



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