By: Julia Aidan
Submitted: 2011-07-08 21:47:44 | Word Count: 646
Index investing through exchange-traded products (ETPs) continues to gain momentum in all asset classes. Despite a global economic downturn in 2008, the pace of new issuance in exchange-traded funds (ETFs) and exchange-traded notes (ETNs) continued. US exchanges added 221 new products that track a variety of new and exotic indexes. Over 500 new funds are in SEC registration as of early 2009, and growth is on track to reach 1,000 ETPs on the market by 2010. New companies entering the marketplace include PIMCO, Charles Schwab and JP Morgan.
New index strategies are unlike traditional indexes that use passive security selection and capitalization weighting. Today, many new indexes use qualitative and quantitative strategies that by default imply active management techniques. Nonetheless, these complex index methods satisfy certain requirements established by the Securities and Exchange Commission to register a new product as an index fund or ETP.
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Index Categorization
Unfortunately, the tools needed by investors to analyze new index products have not kept pace with advances in methodology. Most categorization methods classify products by style such as value versus growth for equity funds and investment-grade versus non-investment grade for bonds funds. That is fine at one level, but it does not explain how an index provider selects securities or manages securities. A new index categorization method introduced in this article approaches the issue from a different perspective by sorting products by index rules rather than investment style.
There are two levels to index rule categorization. At the first level, indexes are separated into two types; benchmark indexes and strategy indexes. A benchmark index is a yardstick that measures total market value while a strategy index is any alternative way to invest in a market. At the second level, investment products can be sorted into nine Index Strategy Boxes™ based on the index rules that those products follow. The boxes help an investor understand the basic security selection and weighting rules governing an index so they can better understanding how a fund that tracks that index is managed.
Benchmark indexes are market valuation tools. They are constructed to measure and compare various financial markets and segments of those markets. Index constituents are selected using passive methods to capture a broad cross-section of securities and those securities are then capitalization weighted in the index. Benchmark indexes are used in global finance for return comparisons and used at the highest level in banking and as economic indicators. They are the 'Beta' of the market in the Capital Asset Pricing Model (CAPM). In addition, investment consultants and advisors use benchmarks as the basis for asset allocation decisions. Finally, a benchmark index represents a passive opportunity set from which all active investors select from, and those indexes are yardsticks by which active management strategies are measured against.
Strategies indexes are alternative methods for investing in the financial markets. Much like active management, their purpose is not to represent a market return. Strategy indexes do not measure Beta, nor are they used as a substitute for Beta. Rather, strategy indexes are designed to intentionally capture a return path that differs from a benchmark index. Strategy indexes are engineered primarily as the basis for investment products. The index provider typically selects securities using other than passive methods, or weights securities using other than market capitalization, or both. Like active management, strategy indexes tend to have a higher turnover than benchmark indexes.
Understanding how Index funds are classified helps investors quickly and easily identify differences in index methodologies and pinpoint desired investment products. That is useful to every investor and every fund provider. Learning the system requires some thought, but once understood the method becomes intuitive and very helpful.
Author Resource:-
Learn more about index fund investing to lower your overall cost of investing and improve the performance of your portfolio. Asset allocation and portfolio rebalancing are key to keeping more of your money working for you.
