Understanding index methodology

Method in the madness

In our last article, we wrote that not all ETFs are created equal and urged investors to look at more than just the label and the cost: labels can mislead and cost doesn’t always equal value, was our message.

Given that there are now approximately 1,591 Exchange Traded Products listed on the London Stock Exchange freely available to investors through investment advisers, fund supermarkets and roboadvisory services, we think this is sound advice. Where on earth do you begin to make sense of it all?

Our Close Tactical Select Passive (TSP) fund range aims to be the purest expression of our 'house view': from Strategic Asset Allocation (SAA) to Tactical Asset Allocation (TAA), and on to index and ETF selection in the passive universe. The index you choose to reflect your world view is crucial: its stock selection methodology (price, yield or capitalisation?); its calculation methodology (market cap weighted?); turnover (high or low?); rebalancing (quarterly?); and tax (net or gross?). These are just a few of the factors to consider. If index turnover is high, for example, then an ETF replicating it might face higher transactional costs which may increase its OCF.

Once we’ve decided on our index, we revert to our approved panel of ETF providers to see which offers our best option. Currently, Close Brothers has a list of over 10 approved providers including some well-known (iShares and Vanguard) and some lesser-known names (First Trust and Lyxor) satisfying our stringent due diligence process. Close Brothers would never invest in an ETF from a provider we have not approved.

You can’t always get what you want

You might think: who cares about methodology? The truth of course is that ETF providers effectively replicate and extrapolate indices within a vacuum and play by their own theoretical rules. Many don’t trade, they only track. It follows that once you’ve defined what you intend to do, you need to find an ETF provider whose methodology can express your intentions as faithfully as possible. Within the checks and balances you would expect from our investment research process, I have certain freedoms in choosing the best way to express our 'House View'.

Let’s say you’re interested in Value. Value factor investing is well documented academically and worth exploring - it’s discussed as often as it is poorly understood. Yet MSCI, S&P and FTSE all define Value differently:

• MSCI: Earnings to price, book to price and Enterprise Value/ Cash from Operations (EV/CFO)
• S&P: Earnings to price, book to price & sales to price
• FTSE: Earnings yield, sales to price and cash flow yield

MSCI alone has at least three variants, namely: Value, Prime Value and Enhanced Value. Returns, tracking error and standard deviation all vary greatly – in fact total returns varied by more than 21% between Value and Enhanced Value, in our proprietary analysis*. One index, one provider with at least three Value methodologies and totally different outcomes! It’s probably around now that madness starts to set in if you’re going it alone!

Not always the name

First Trust US Equity Income UCITS ETF, held in the Close TSP fund range, is a case in point. Although not labelled Value, its method for stock inclusion results in a Value-orientation. Potential constituents must generally correspond to the price and yield of the NASDAQ US High Equity Income Index before applying factors including liquidity, dividend yield and dividend growth and then filtering by their debt-to-assets ratio (<75%), three-year dividend payout ratio (<90%) and positive free cash flow. Finally, the companies are weighted by net income minus dividends paid. It is rebalanced semi-annually.

Passives always diversify, right?

From this ensues a logical conclusion: that this filtering, or weeding out, of undesirable names, also concentrates your focus and possibly your risk. This kind of methodology takes you to Smart Beta and sector ETFs. Whether this is intentional or accidental takes us circuitously to where we began – what is it that you want to express with this index? Regulations are also at play here. In Europe, UCITS has its 5/10/40 rule: no one stock may be greater than 10% and those between 5% and 10% weightings can in aggregate be no more than 40% of the ETF created. Thus, index providers adhere to these rules at the index methodology stage so the UCITS ETF providers
can actually track the index in question. And consequently, there might be performance differences between US-domiciled ETFs that don’t have this 5/10/40 diversification rule and their EU counterparts.

Value added

As the ETF market has grown in popularity, so too has our choice. But for many investors this means confusion rather than profusion - a layperson can easily be blind-sided or, worse still, misunderstand the cost of getting it wrong. At Close Brothers Asset Management, we believe that doing this spade work for our clients adds significantly and measurably to both their returns and their experience of investing through our Close TSP fund range.

*MSCI Indices Total Return, 5 years to end June 2018.

Important information
This article is only intended for use by UK investment professionals and should not be distributed to or relied upon by retail clients.  The value of investments will go up and down and clients may get back less money than they invested. Past performance is not a reliable indicator of future returns. The information contained in this document is believed to be correct but cannot be guaranteed. Opinions constitute our judgment as at the date shown and are subject to change without notice. This document is not intended as an offer or solicitation to buy or sell securities, nor does it constitute a personal recommendation.