EVALUATING INDEX TRADEABILITY A BRIEF CROSS-ASSET CLASS REVIEW

Article published in the September/October issue of the Journal of Indexes Europe, available at www.indexuniverse.eu/joi
When the first equity index, the Dow Jones Industrial Average, was brought to market in 1896, it consisted of only twelve stocks and was merely an approximate gauge to the performance of the US stock market. Much has evolved since then; today the market abounds with indices covering almost all segments of the global equity and fixed income markets including frontier markets, micro-capitalisation stocks and emerging market local currency debts. More importantly, indices are no longer simply benchmarks, used only for performance measurement but now often serve as the basis for index-linked investments, giving investors access to diverse strategies at a low cost. The broad application of indices stretches far beyond traditional asset classes, such as equities and fixed income, to include alternative investments. For instance, the launch in 1991 of the first tradeable futures1 based commodity indexthe GSCI has provided an efficient means of obtaining diversified exposure to this asset class. It has also facilitated the opening up of this once niche market to mainstream investors. A more recent example is volatility, where the role of indices has been instrumental in increasing trading volume. Indeed, despite being a widely monitored indicator, the Chicago Board Options Exchange Volatility Index (VIX)often referred to as the fear indexwas once not tradeable. However, the launch of VIX futures in 2004, and the subsequent development of VIX futures indices and exchange-traded products have made volatility products accessible to a broader range of market participants. In order for an index to be transformed from a passive benchmark to an active investment tool, it must be tradeable. The tradeability of an index ultimately relies upon its widespread adoption in the marketplace, and its construction requires the meticulous balancing of often competing factors, which inevitably lead to trade-offs. This article assesses the tradeability of indices across different asset classes, with a particular focus on index construction. Contributors:
Xiaowei Kang, CFA Director Index Research & Design xiaowei_kang@spdji.com Daniel Ung, CAIA, FRM Associate Director Index Research & Design daniel_ung@spdji.com

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Standard & Poors acquired the GSCI from Goldman Sachs on February 2, 2007 and it was subsequently renamed the S&P GSCI.

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Traditional Asset Classes: Equities and Fixed Income

Indices based on conventional asset classes, such as equities and fixed income, serve both as benchmarks and investment tools. For benchmark indices where the predominant goal is performance measurement, representativeness of the underlying markets and investment styles is obviously the prime consideration. On the other hand, indices designed for investment purposes should focus on liquidity, albeit often at the expense of representativeness. That said, there is no industry consensus on the exact definitions of benchmarks and tradeable indices. The Russell 3000 Index, for example, whilst a broad market benchmark, is also an investable index. Similarly, the S&P 500 is the basis for some of the most liquid exchange-traded funds, index futures and options, whilst being an oft-cited benchmark for US largecapitalisation stocks. Investable indices must therefore carefully weigh up the need for market representativeness and the requirement for trading liquidity. Figure 1 lists a number of ways in which tradeability and breadth can be achieved for equity and fixed income indices. Figure 1: Common Criteria for Achieving Tradeability and Representativeness
Methodology for Liquidity / Tradability Include limited number of stocks Minimum float adjusted market cap Minimum trading volume or value traded Minimum turnover ratio Frequency of trading Use liquidity weighting instead of market cap weighting Use liquid ADR/GDR instead of local listing Include limited number of bonds Minimum amount outstanding Minimum time to maturity Exclude less liquid bond types Methodology for Representativeness

Equity Indices

Include the largest stocks by market cap Minimum market coverage ratio Representation across equity risk factors such as countries, sectors and styles

Fixed Income Indices

Include the largest bonds/issuers by amount outstanding Representation across fixed income risk factors such as sectors, maturities and quality

Common criteria to ensure the tradeability of an index include restricting the number of constituents in the index and specifying eligibility criteria pertaining to the size and liquidity of stocks (Figure 1). This may involve using liquidity rather than market-capitalisation weighting schemes and, as far as emerging markets are concerned, using ADR or GDR-equivalents rather than the less-transacted local listings. Analysis shows that a portfolio of 75 Eurozone stocks weighted by liquidity increases the maximum trading 2 size of the index basket by almost five times , when compared with the same portfolio of stocks weighted by market capitalisation. Market representativeness is usually achieved by matching the common risk exposures of the index to those of the market portfolio whilst minimising idiosyncratic risk through the selection of the largest stocks or bonds. Figure 2 shows, with a stylised example of a Eurozone equity index, how a rise in the number of stocks included in the index results in a remarkable fall in the median stock liquidity, as measured by the average daily value traded.

2 The maximum trading size is estimated as the minimum 3-month average daily value-traded divided by the portfolio weight of each constituent member.

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Figure 2: The Trade-off between Tradeability and Representativeness (Top Eurozone Stocks)
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0% Top 50 Top 75 Top 100 Top 150 Top 200 Top 400 Market Coverage (%, LHS) Median ADVT ($ Million, RHS)

Source: S&P Dow Jones Indices. Data as of 1 June 2012. Graphs and tables provided for illustrative purposes only.

Nonetheless, it is noteworthy that, irrespective of the finer minutiae of the design methodologies, wellconstructed tradeable equity and fixed income indices should successfully capture the market beta and the related common risk factors. Figure 3 demonstrates that the performance of the S&P Euro 75, a tradeable index weighted by liquidity, comports with that of the overall market, as defined by the MSCI EMU Index, over the last ten years. Similarly, the return of the more narrowly defined Markit iBoxx USD Liquid Investment Grade Index is in line with the more comprehensively defined Barclays U.S. Corporate Investment Grade Index. Figure 3: Performance of Tradeable Indices against the Relevant Benchmarks
Eurozone Equities 200 175 150 125 100 75 50 Jan-03 Jan-05 Jan-07 Jan-09 Sep-03 Sep-05 Sep-07 Sep-09 Jan-11 May-02 May-04 May-06 May-08 May-10 Sep-11 May-12 200 180 160 140 120 100 80 Jan-03 Jan-05 Jan-07 Jan-09 Sep-03 Sep-05 Sep-07 Sep-09 Jan-11 May-02 May-04 May-06 May-08 May-10 Sep-11 May-12 U.S. Investment Grade Corporate Bonds

MSCI EMU IMI

S&P Euro 75

Barclays U.S. Corporate IG Index

Markit iBoxx USD Liquid IG Index

Source: S&P Dow Jones Indices, MSCI, Barclays Capital, Markit. Graphs and tables provided for illustrative purposes only. Past performance is not a guarantee of future results. Please see the Performance Disclosure at the end of this article for more information on some of the inherent limitations associated with back-tested Index data and performance information. It is not possible to invest directly in an index.

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Futures-Based Indices: Commodities and Volatility

Direct investments in certain asset classes can prove impractical and very costly. However, in markets where the trading of futures is reasonably active, indices can lead the way in opening up the market to new categories of market participants. This is true for both the commodity and volatility markets. The commodity market was once dominated by hedgers but in 1991, Goldman Sachs structured the first tradeable commodity index as the basis for investment products. Likewise, VIX futures indices have brought retail investors to the volatility market, once the preserve of institutional investors. Qualities such as market representativeness and high liquidity apply to indices of the traditional asset classes as they do to commodities. Though, on account of the manner in which commodity indices are designed -- using futures rather than spot price -- an additional consideration is necessary to balance exposure to the spot market and roll costs. Indeed, even though there is a positive correlation between the spot price and the futures price, convergence of the two prices does not take place until the expiry of the futures contract. Classical or first generation commodity indices, such as the standard S&P GSCI, typically roll their futures position in the front-month contract forward to the next available contract. Since 2005, with most commodity markets in contango, the rolling of futures, which involves the purchase of a dearer longer-term contract and the simultaneous sale of a cheaper expiring contract, has substantially depressed returns. Given that roll return is one of the dominant drivers of performance, an array of indices have been developed to offset contango. Most of the innovations have centred on minimising roll costs (negative roll return) via placement, whereby futures positions are rolled out to longer maturities. This has the effect of lessening the drag on performance, which tends to be most severe at the front end of the futures curve. Innovation came in the form of enhanced indices, such as the S&P GSCI Enhanced Index, which utilises a broader part of the forward curve, but still has a pre-determined roll schedule. More recent developments have focussed on introducing flexibility in this process. For instance, the S&P GSCI Dynamic Roll Index adopts a more sophisticated approach by rolling a futures position only when it is deemed necessary, 3 based on the Dynamic Roll Parity Principle . Combined with this, the universe of eligible contracts into which rolling can take place has also expanded and takes into account the specificities of the different commodity markets. Together, these new features can potentially push down turnover costs by reducing trading frequency as well as alleviating the costs of negative roll in contango markets. Between 2005 and 2012, the standard S&P GSCI recorded a performance of -32.5% whereas the S&P GSCI Enhanced and S&P GSCI Dynamic Roll saw returns of 2.18% and 35.1%, respectively, over the same period (Figure 4). Doubtless, the later generation of indices has improved returns. However, the enhanced return comes with compromises, in the form of a reduction in market beta exposure and liquidity, as indicated in the example of Brent Crude Oil (Figure 5). The analysis does not purport to have an optimal solution to resolve this trade-off. Ultimately, where the balance should be struck will depend on the objectives of the investment. Investors wishing to track spot prices closely over the short term may prefer the standard commodity indices offering both a higher beta exposure and liquidity. On the other hand, investors with a longer term horizon may be more concerned about roll costs and opt for enhanced or dynamic roll indices.

Dash and Tsui, 2011. For a given commodity, if the rolled-out contract is part of the pre-specified optimal set of contracts, the same contract will continue to be used. Otherwise, the top-ranking contract within the optimal set will be used instead.

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S&P DOW JONES INDICES | EVALUATING INDEX TRADEABILITY Figure 4: Performance of Different Commodity Strategies
250 225 200 175 150 125 100 75 50 Mar-06 Mar-07 Mar-08 Mar-09 Mar-10 Mar-11 Sep-06 Sep-07 Sep-08 Sep-09 Sep-10

September 2012

Sep-11

S&P GSCI Enhanced ( = 24.7%) S&P GSCI Dynamic Roll ( = 20.9%) Source: S&P Dow Jones Indices. Data as of 31 May 2012. denotes annualized standard deviation. Graphs and tables provided for illustrative purposes only. Past performance is not a guarantee of future results. Please see the Performance Disclosure at the end of this article for more information on some of the inherent limitations associated with back-tested Index data and performance information. It is not possible to invest directly in an index.

S&P GSCI ( = 26.3%)

S&P GSCI 2-month Forward ( = 25.3%)

Figure 5: Trading Brent Crude Oil Futures Trade-Off between Liquidity, Beta Exposure and Roll Cost
5000 4500 4000 3500 3000 2500 2000 1500 1000 500 0 Front Month 2-Month 3-Month 4-Month 100% 95% 90% 85% 80% 75% 70% 65% 60% 55% 50% 45% 40% S&P GSCI Standard Index S&P GSCI S&P GSCI S&P GSCI 1-Month Enhanced 2-Month Forward Index Forward Index Index Annualised Roll Cost (%, RHS) S&P GSCI 3-month Forward Index S&P GSCI Dynamic Roll Index 0% 5% 10% 15% 20%

Average Monthly Trading Volume ('000) of Brent Crude Oil Futures

Beta to Brent Crude Oil Front Month Price (%, LHS)

Source: S&P Dow Jones Indices. Data as of 31 May 2012. Graphs and tables provided for illustrative purposes only. Past performance is not a guarantee of future results. Please see the Performance Disclosure at the end of this article for more information on some of the inherent limitations associated with back-tested Index data and performance information. It is not possible to invest directly in an index.

Besides commodities, volatility is another example of the application of futures-based indices. Spot volatility, as measured by the VIX, is not tradeable as the index represents the weighted average of implied volatilities of various options on the S&P 500. Prior to the introduction of VIX futures on the Chicago Board Options Exchange in 2004, equity volatility was only traded by sophisticated counterparties by way of overthe-counter instruments, such as variance swaps. Since then, VIX futures and options have gradually gained acceptance but trading was confined principally to sophisticated players in the derivatives market. More recently, the ongoing economic downturn and the introduction of S&P VIX Futures indices in 2009 have made volatility a popular alternative asset class with many products offered in this space (Dash and Liu, 2010). Interestingly, the development of ETNs and ETFs linked to these indices has also significantly enhanced the liquidity of the underlying VIX futures.
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It is well-known that implied volatility exhibits a strong, negative correlation with equity markets and often spikes up during market turmoil. To that end, volatility indices serve to provide directional exposure to spot VIX, either as a trading vehicle or as a hedging instrument to attenuate tail risk events. From this, it follows that the sensitivity to the spot VIX, namely the beta, has to be a critical factor in the design of volatility indices. In addition, as in commodity indices, the liquidity of the underlying futures contracts as well as the costs associated with the rolling of the futures are also important considerations. As can be observed in Figure 6, the liquidity of VIX futures, as measured by average daily trading volume, is concentrated in the one-month and two-month contracts, and drops quickly thereafter. Moreover, the volatility beta of the VIX futures indices and the roll costs fall as maturities lengthen. These characteristics indicate that there are trade-offs between liquidity, beta exposure to spot VIX and roll costs. Figure 6: Trading VIX Trade-off between Liquidity, Beta Exposure and Roll Cost
40 35 30 25 20 15 10 5 0
1-Mo. 2-Mo. 3-Mo. 4-Mo. 5-Mo. 6-Mo. 7-Mo. 8-Mo. Futures Futures Futures Futures Futures Futures Futures Futures

50% 40% 30% 20% 10% 0%

Short-Term 2-Mo. Index3-Mo. Index4-Mo. Index Mid-Term 6-Mo. Index Dynamic Index Index VIX Index

5% 4% 3% 2% 1% 0%

Average Daily Trading Volume ('000) of VIX Futures with different Maturities

Beta of VIX Futures Indices to VIX Spot (%, LHS) Average Monthly Roll Cost of VIX Futures Indices (%, RHS)

Source: S&P Dow Jones Indices. Data as of 31 May 2012. Graphs and tables provided for illustrative purposes only. Past performance is not a guarantee of future results. Please see the Performance Disclosure at the end of this article for more information on some of the inherent limitations associated with back-tested Index data and performance information. It is not possible to invest directly in an index.

The growing sophistication of market participations has brought about the launch of products catering to the varying needs of different clientele. The S&P 500 VIX Short term Futures index is a strategy that invests in the front end of the futures curve. It is constructed by maintaining a constant one-month maturity through the rolling daily from the one-month to the two-month futures contract. By dint of its focus on futures of short maturities, the index offers a high beta to spot VIX and high liquidity, although the roll costs are high. These attributes make it suitable to capture directional exposure of the VIX over short periods of time or serve as a short-term hedging instrument. By contrast, the S&P VIX Mid-Term Futures Index is more adapted to investors seeking a longer term exposure to volatility for both hedging and investment purposes. It constantly maintains a five-month maturity by rolling to four, five, six and seven-month VIX futures and has significantly lower roll costs. Other strategies are also available, including the S&P 500 VIX 2-month, 3-month, 4-month and 6-month which follow a similar logic by rolling between two or more futures contracts with consecutive maturities. Another approach that aims to optimise the costs of rolling with beta exposure is by adopting a dynamic volatility strategy, such as the S&P 500 Dynamic VIX Futures Index. The strategy relies upon the term structure of volatility. In volatile environments, an increased allocation is made to short-term futures so as to better capture the beta exposure and, in more stable environments, a higher proportion is assigned to medium term futures in order to alleviate the costs of rolling.

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Equity-Based Exposure to Alternative Asset Classes

Owing to the opacity of the investment strategies in certain sectors - like private real estate and private equity, it is unfeasible to construct tradeable indices that can capture the returns of direct investments. Moreover, such investments are usually only available to sophisticated investors. This is why some investors may prefer to obtain broad exposures to these asset classes through more tradeable equity alternatives Before examining the tradeability of these assets, it is appropriate to begin by making distinctions between private equity/real estate funds and publicly quoted stocks operating in these arenas. Chief amongst them is the uncertainties and potential costs related to the liquidity of fund holdings and the timing of capital calls. This differs markedly from investing in stocks where trading is continuous and no distinction is drawn between investments and capital commitments. Furthermore, there is strong evidence that both private equity and real estate returns persist across different funds of the same manager, implying that skill is a key ingredient in determining success (Hahn et al, 2005; Kaplan and Schoar, 2005). This contrasts from mutual funds where return persistence has been detected in underperformance rather than outperformance (Carhart, et al, 2002). Given the differences identified, a stocks-based investment inevitably involves compromises, the most important of which relates to the trade-off between the access to manager skill and investability. In spite of this, stocks-based private equity and REITs indices - such as the S&P Listed Private Equity Index and S&P US REIT Index are used as alternatives for investors who do not wish or do not have the capacity to obtain direct exposure to private equity and private real estate funds. Moreover, they are also used as a means of implementing tactical asset allocation decisions involving these asset classes. However, whilst these indices do provide some exposure, there can be notable differences in the performance between the returns of the underlying asset classes and those of equity indices, depending on the time period in question. This is because equity investments are driven by both the risk of the underlying asset class and broad equity market risk, and may not track the performance of the underlying asset class closely (Figure 7). Figure 7: Performance of REIT Index and Listed Private Equity Index versus the Underlying Asset Classes
300 250 200 150 -10% 100 50 Mar-04 Mar-07 Sep-02 Sep-05 Sep-08 Mar-10 Jun-03 Jun-06 Jun-09 Sep-11 Dec-01 Dec-04 Dec-07 Dec-10 -30% -50% -70%
Cambridge Associates Private Equity Funds S&P Listed Private Equity

70% 50% 30% 10% 2004 2005 2006 2007 2008 2009 2010 2011

NCREIF Property Index S&P 500

S&P US REIT

Source: S&P Dow Jones Indices, NCREIF, Cambridge Associates. The NCREIF Property Index measures the performance of a large pool of individual commercial real estate properties acquired in the private market for investment purposes only. The Cambridge Associates Private Equity Index measures the performance of US private equity funds. Graphs and tables provided for illustrative purposes only. Past performance is not a guarantee of future results. Please see the Performance Disclosure at the end of this article for more information on some of the inherent limitations associated with back-tested Index data and performance information. It is not possible to invest directly in an index.

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Conclusions
Our review suggests that there are trade-offs between tradeability and other considerations with regards to index construction. Traditional asset classes, such as equities and fixed income, can usually reconcile well between the requirement for market representativeness and tradeability. In futures-based indices, the trade-offs involve not only representativeness and tradeability, but also the beta exposure to spot and roll costs. Finally, in other alternative asset classes, such as private equity and real estate, obtaining exposure via equity instruments often comes at the cost of higher tracking error and the inability to access manager skills. For this reason, investors should adopt a multi-dimensional perspective when evaluating index tradeability.

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About S&P Dow Jones Indices Research & Design

S&P Dow Jones Indices is one of the worlds leading index providers, maintaining a wide variety of investable and benchmark indices to meet a wide array of investor needs. Our research team is dedicated to conducting unbiased and in-depth analysis on a broad range of topics and issues facing investors in todays marketplace. Research by S&P Dow Jones Indices Index Research & Design provokes discussion on investment matters related to benchmarking in the asset management, derivatives and structured products communities. The series covers all asset classes and is often used to float new indexing concepts or explain substantive changes to well-known S&P Dow Jones indices. For more articles on a broad range of index-related topics or to sign up to receive periodic updates, visit us at www.spindices.com/spdji.

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References
Carhart, M., J. Carpenter, A. Lynch, and D. Musto, 2002, Mutual Fund Survivorship, Review of Financial Studies 15: 1439-1463. Dash, Srikant and Liu, Berlinda, 2010. Access to Volatility via Listed Futures, S&P Indices Whitepaper. Dash, Srikant and Tsui, Peter, 2011. Dynamic Roll of Commodities Futures: An extended framework, S&P Indices Whitepaper. Hahn, Thea, Geltner, David and Gerardo-Lietz Nori, 2005. Real Estate Opportunity Funds: Past Fund Performance as an Indicator of Subsequent Fund Performance, Journal of Portfolio Management Kaplan, Steven and Schoar Antoinette, 2005. Private Equity Performance: Returns, Persistence and Capital Flows, The Journal of Finance.

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PERFORMANCE DISCLOSURE
The launch date of the S&P Euro 75 Index was November 29, 2010 at the market close. All information presented prior to the index inception date is back-tested. Back-tested performance is not actual performance, but is hypothetical. The back-test calculations are based on the same methodology that was in effect when the index was officially launched. Complete index methodology details are available at www.spindices.com. The launch date of the S&P GSCI Enhanced Index was September 22, 2009 at the market close. All information presented prior to the index inception date is back-tested. Back-tested performance is not actual performance, but is hypothetical. The back-test calculations are based on the same methodology that was in effect when the index was officially launched. Complete index methodology details are available at www.spindices.com. The launch date of the S&P GSCI Dynamic Roll Index was January 27, 2011 at the market close. All information presented prior to the index inception date is back-tested. Back-tested performance is not actual performance, but is hypothetical. The back-test calculations are based on the same methodology that was in effect when the index was officially launched. Complete index methodology details are available at www.spindices.com. The launch date of the S&P 500 VIX Mid-Term Futures Index and S&P 500 VIX Short-Term Futures Index was January 22, 2009 at the market close. All information presented prior to the index inception date is back-tested. Back-tested performance is not actual performance, but is hypothetical. The back-test calculations are based on the same methodology that was in effect when the index was officially launched. Complete index methodology details are available at www.spindices.com. The launch date of the S&P 500 2-month Futures Index, S&P 500 VIX 3-month Futures Index, S&P 500 VIX 4-month Futures Index and S&P 500 VIX 6-Month Futures Index was August 25, 2011 at the market close. All information presented prior to the index inception date is back-tested. Back-tested performance is not actual performance, but is hypothetical. The back-test calculations are based on the same methodology that was in effect when the index was officially launched. Complete index methodology details are available at www.spindices.com. The launch date of the S&P Private Equity Index was March 12, 2011 at the market close. All information presented prior to the index inception date is back-tested. Back-tested performance is not actual performance, but is hypothetical. The back-test calculations are based on the same methodology that was in effect when the index was officially launched. Complete index methodology details are available at www.spindices.com. Past performance is not an indication of future results. Prospective application of the methodology used to construct the S&P Global Infrastructure Index, the S&P Emerging Markets Infrastructure Index, the Dow Jones Brookfield Global Infrastructure Index, and the Dow Jones Brookfield Emerging Markets Infrastructure Index may not result in performance commensurate with the back-test returns shown. The back-test period does not necessarily correspond to the entire available history of the index. Please refer to the methodology paper for the index, available at www.spdji.com or www.spindices.com for more details about the index, including the manner in which it is rebalanced, the timing of such rebalancing, criteria for additions and deletions, as well as all index calculations. It is not possible to invest directly in an Index. Another limitation of back-tested hypothetical information is that generally the back-tested calculation is prepared with the benefit of hindsight. Back-tested data reflect the application of the index methodology and selection of index constituents in hindsight. No hypothetical record can completely account for the impact of financial risk in actual trading. For example, there are numerous factors related to the equities (or fixed income, or commodities) markets in general which cannot be, and have not been accounted for in the preparation of the index information set forth, all of which can affect actual performance. The index returns shown do not represent the results of actual trading of investor assets. S&P/Dow Jones Indices LLC maintains the indices and calculates the index levels and performance shown or discussed, but does not manage actual assets. Index returns do not reflect payment of any sales charges or fees an investor would pay to purchase the securities they represent. The imposition of these fees and charges would cause actual and back-tested performance to be lower than the performance shown. In a simple example, if an index returned 10% on a US $100,000 investment for a 12-month period (or US$ 10,000) and an actual asset-based fee of 1.5% were imposed at the end of the period on the investment plus accrued interest (or US$ 1,650), the net return would be 8.35% (or US$ 8,350) for the year. Over 3 years, an annual 1.5% fee taken at year end with an assumed 10% return per year would result in a cumulative gross return of 33.10%, a total fee of US$ 5,375, and a cumulative net return of 27.2% (or US$ 27,200).

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DISCLAIMER
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