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How to make your own index?

Discussion in 'Stock Market Nuts and Bolts' started by DJG, Aug 10, 2014.

  1. DJG


    Likes Received:
    Mar 29, 2010
    Random question and more or less curiosity.

    So I understand how an index is created (or priced might be a better way to put it).

    How do these indices actually get popularity and traction?
    Do the creators actually earn money from 'selling' the index to an ETF type manager?

    Such as say the ETFs that track a certain index currently. Or do they basically just track the same companies within the index and don't have to pay for any form of licensing?
  2. DeepState

    DeepState Multi-Strategy, Quant and Fundamental

    Likes Received:
    Mar 30, 2014
    1. There are many types of indices. Some are market cap weighted. Others are created via some sort of formula. An example might be the MSCI Low Volatility style of index. This is based off a set of calculations which are rebalanced periodically. They are most certainly not market capitalization weighted. I would use the term constituted.

    2. The bulk indices that represent broad exposure to an asset class like Australian equities, World equities, US Treasury.... are exposures which a lot of retail and insto want. So they buy in en masse. The keys there are having a sales force which goes around to the advisers of retail and HNW individuals and explaining to them the benefits of doing so. These pretty much boil down to high transparency and low cost. For insto, these things are super liquid and have displaced the use of futures to a reasonable degree as an exposure management tool. Getting in first can be important if the offering is a bulk fund because liquidity begets liquidity...and large funds become the hub. Take a look at the relative sizes of the SSGA Aust Eq ETF vs BLK iShares equivalent for an example.

    Another way of selling is to have some talking heads pointing out which market looks good, why you should buy it etc. etc. Generates some hype. However, there usually is a genuine reason why this is a good idea because reputations are trashed if the outcomes are poor time and again. Each of the major ETF providers have something which generates information that is provided to potential consumers who can then do what they think is right with it. This is most influential in the intermediated retail and HNW markets.

    3. Index providers used to have virtually no pricing power in the market. Now their brand has become vital to the value chain. Whilst it is possible for ETF providers to outline the index methodology to be used in an ETF and sell it as such, for whatever reason, there is a desire to have a independent index supplier. This costs money. To me, this is pretty silly, because the difference between indices is usually tiny and all you are really buying is a S&P or FTSE or Russell or MSCI moniker because the market just wants it that way. If the market didn't care so much for this false sense of security, the index would cost about $30k (or less...it is automated once the rules are coded and coding isn't usually hard) to calculate and maintain. The rules can be given to whoever wants them and the results subject to audit. Anyhow, the market has reached this point, but the ETF providers are looking to cut the index providers' lunch. With respect to the implied independence and associated protections arising from index providers, it seems that perception is reality at the moment.

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