Types of equity, bond and alternative investment indexes

What types of equity index exist?

There are four kinds: broad market, multi-market, sector and style. The first three differ by what they cover. Style indexes differ by how they group shares.

Type	What it covers	Note
broad market index	most of one country’s market value, usually over 90%	the usual “market” proxy
multi-market indexes	several countries or regions, from regional up to the world	often cut by economic development: developed, emerging, frontier
sector indexes	one economic sector, nationally, regionally or globally	used to analyze cyclical and defensive behavior
style indexes	groups by size (large, mid, small) and by value or growth	high turnover, shares migrate between styles

Equity indexes

• Broad market Memorize most of one market, usually over 90% of its value
• Multi-market Memorize several countries or regions, up to the whole world
  • By development developed, emerging, frontier
  • By region Americas, Europe and Africa, Asia and Pacific
• Sector Memorize one economic sector, national, regional or global
• Style Memorize size, value or growth, or a mix
  • Size large, mid, small
  • Value or growth by valuation ratios
  • Six basic styles three sizes by value or growth

Multi-market. Providers classify countries by development and by region, and review the classifications from time to time. When a country moves from frontier to emerging, or emerging to developed, the indexes are reconstituted. Weighting is usually by market value, but some providers weight countries by their share of world economic output (gross domestic product, GDP) and then weight shares within each country by market value. That is fundamental weighting applied across markets, and it cuts the weight of a country whose stock market is large relative to its economy.

Sector. Sector indexes come in families, and the sectors of a family together are equivalent to a broad market index. No sector classification is universal, so providers differ. Sector indexes help to tell whether a manager is better at stock selection or at choosing sectors, and they are model portfolios for sector funds.

Style. Size can be set by absolute market value (below a stated amount) or by relative rank (the smallest 2,500 shares). Value and growth are set by valuation ratios such as low price-to-book, low price-to-earnings or high dividend yield. Crossing three sizes with value and growth gives six basic styles. Because ratios and market values change, shares frequently move from one style index to another on reconstitution dates, so style indexes have much higher turnover than broad market indexes.

Why are fixed-income indexes hard to build?

Three features of bond markets cause the trouble: the number of securities, thin trading and dealer pricing. A fixed-income index represents a segment of the bond market.

1. The universe is huge and always changing. Governments, agencies and companies each issue many bonds with different terms, so there are many times more bonds than shares. Bonds mature and new ones are issued, so the index has high turnover.
2. Bonds trade mostly through dealers. Many bonds trade rarely, so the provider must ask dealers for prices or estimate them from similar bonds that do trade.
3. Replication is costly and difficult. With thousands of bonds and poor liquidity, copying a bond index costs more than copying an equity index, and the number of bonds used for the same market differs between providers.

Bonds can be classified along several dimensions, and fixed-income indexes follow them.

Fixed-income indexesaggregate, market sector, style, economic sector, specialized

• Issuer type government, agency, corporate
• Financing type general obligation, collateralized
• Currency of the payments
• Maturity short, medium, long
• Credit quality investment grade, high yield
• Inflation protection present or absent

An aggregate index covers the broad market of a country or the world across government, agency, corporate and securitized bonds. It can be cut by market sector, style (maturity, credit quality), economic sector or specialized themes such as high yield, inflation-linked or emerging market bonds. A common split is investment grade versus high yield, with investment grade cut again by maturity and rating.

Go deeper The problem with weighting a bond index by amount outstanding

Most bond indexes weight each issuer by the market value of its debt. That gives the biggest weights to the borrowers with the most debt, whatever their ability to repay. A portfolio that tracks the index lends most to the most indebted issuers. Critics call this the “bums” problem, and it is one reason some providers offer alternatives that weight differently.

What do indexes for alternative investments look like?

Three alternative classes have widely followed indexes: commodities, real estate and hedge funds. Each has a distinct construction problem.

Commodity indexes. A commodity index consists of futures contracts on commodities such as grain, livestock, metals and energy, not the physical goods. With no obvious weight like market value, each provider picks its own method: equal weights, weights by world production or liquidity, or fixed committee weights. Two indexes with some of the same commodities can behave very differently, for instance if one has far more energy. The index return comes from the risk-free interest on the collateral, the change in futures prices and the roll yield from replacing expiring contracts with new ones. That is why a commodity index can differ from the spot price trend.

Real estate indexes. Real estate is an illiquid market with few transactions, so prices are scarce. There are three index types. Appraisal indexes are based on valuations, which are smoothed and lag the market. Repeat-sales indexes use the price changes of properties that sold more than once. A REIT index contains listed shares of real estate investment trusts, which trade continuously, so its value is calculated continuously.

Hedge fund indexes. A hedge fund index is built from the returns of hedge funds. Funds are private and report voluntarily, usually to one database, so the constituents determine the index, not the provider. Most indexes are equal-weighted. Two biases push reported returns up.

• survivorship bias : funds that perform badly or close stop reporting and drop out, so the index reflects the survivors.
• backfill bias : a fund that starts reporting after a good run can bring its earlier history with it, so strong results enter the database and weak starts do not.

Because funds report to different databases, different hedge fund indexes overlap little, and they can show very different results for the same period.

Exam tip Question says the index “looks too good”? Think hedge fund index: survivorship and backfill both push returns up.

Go deeper Why commodity index returns can fall when spot prices rise

A commodity index must replace each expiring futures contract with a later one. When later contracts cost more than the near one (contango), each roll buys at a higher price than the position just sold, which costs money. Spot prices can rise modestly while the index loses on this roll yield. When later contracts are cheaper (backwardation) the roll earns a gain. The Derivatives and Alternative Investments topics return to this.

Go deeper Repeat-sales indexes and sample selection

A repeat-sales index measures how the price of the same property changed between two sales, which avoids comparing different buildings. It uses only the properties that sold at least twice, so it excludes homes held for a long time and may not represent the whole market. The sample is the catch, as the survivors are in the hedge fund case.