The financial crisis has steered investors away from complex financial products towards more transparent, liquid investments. The natural choice might be a retreat to the well-known benchmark indices. But are these always the best choice?
For much of late 2008 and 2009, the market was driven very much by macro factors. We saw big swings as equity markets responded to the changing economic environment. Now, as the global economy appears to be stabilising, it is a good time for investors to look at where the winners and losers of the future could emerge. There may be greater opportunity for returns in particular sectors or regions, or from companies with certain characteristics. Broad benchmark investing cannot always capture these opportunities effectively. Actively managed investments are one option, but custom indices are also worth considering.
Most investment banks now offer a range of custom or proprietary indices. Some are very much “black box” strategies, but others are as transparent as well-known market benchmarks, have good liquidity and use simple, logical criteria to screen and select stocks. What is the appeal of these custom stock screens and how should investors choose between them?
What is the investment strategy?
Custom indices vary widely. Sometimes the index might be based on a well-known investment process, such as value or growth screening. Sometimes it might be more specialised or based on specific investment research. Investors should consider the quality of that research, perhaps by looking at the reputation of that research department within the industry.
At Morgan Stanley, we often look to our highly-rated research department for inspiration. For example, our Target Equity Index family is based on research by our European Equity Strategy Team that analysed how private equity firms and corporate buyers identify takeover targets, with the purpose of identifying the metrics underlying those selections. Their study suggested that the characteristics that could attract a corporate buyer might also be attractive to long-term investors and could be developed into an investible index.
Once an investor has decided that they agree with the rationale for stock selection, there are other questions to ask about how the index is constructed. In particular:
• Is the index methodology well-defined? Does it follow clear rules? There should be a detailed description available from the index provider explaining the methodology behind the index.
• Have the stocks been screened for liquidity? An index is liquid where its constituent stocks are liquid and the more liquid an index, the more investment options will be available to invest in such index, including via structured products with capital protection.
• Are there any sectors/regions excluded from the index? Understanding whether specific market segments have been excluded can help to understand performance biases and also to select an appropriate benchmark for comparison.
• How frequently does the screening take place? As the past 12 months exemplify, market conditions can change quickly, and stocks with favourable characteristics now may not have favourable characteristics in six months time. So it is important that the index is dynamic and rebalanced regularly.
Interpreting performance statistics
In assessing the opportunity for investing in an index, potential investors should also consider performance statistics. There is a usually a wealth of performance data available on custom indices, including many years of past performance. Although past performance should not be used as a guide to the future, most investors are interested in how a particular strategy performed in the past. So what should investors be looking out for?
• “Live” versus “simulated” performance. The most useful past performance data is for a live index – when the index is being calculated and is open for investment. However, many custom indices are relatively new and index providers want to give a picture of how an index would have performed if it had been available for longer. These historical simulations can be useful but you should read the small print: was the methodology exactly the same for the simulated performance as for the live performance? You should also bear in mind that simulated performance is likely to show positive data, since it is calculated with the benefit of hindsight. The index provider should make it clear to investors which data is simulated and which is live so they can make a well-informed judgement about the index’s track record.
• Consistency. How has the strategy performed over different parts of the market cycle? Are there any periods of extreme underperformance/overperformance that need further explanation?
• Comparison with other strategies and benchmarks. The more you know about an index, the easier it is to compare one index with another. It is important to look at the overall risk/reward of an index, rather than just the return. Sharpe Ratios and information ratios can be useful ways of comparing different indices, since they take into account volatility as well as performance.
