Financial Indices. An Overview. Michael Walker

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1 Financial Indices An Overview Michael Walker The objective of this white paper is to provide an introduction to financial indices. This includes a discussion on the basics of financial indices, an overview of index methodologies and a detailed insight into the index life cycle, creation and maintenance processes. This paper concludes with a review some of the commonly cited challenges encountered when designing an index creation engine (ICE).

2 Contents 1 Introduction 3 2 Index Methodologies 4 3 Index Creation Process 6 4 Index Maintenance 9 5 Challenges in ICE Design 10 6 About HCL Technologies 11 2

3 1 Introduction What is an index? In financial economics, an index is a measure of the proportionate, or percentage, change in a set of values (prices or quantities) over time. In the case of financial indices, this is the prices of stocks, bonds and other forms of investment. An index is typically assigned the value of 100 in some base period. The values of the index in subsequent periods indicate the average proportionate change in prices (or quantities) from the base period. What types of indices exist? Many types of indices exist in today s financial markets. These include price indices (such as the CPI), quantity indices (such as real GDP), market performance indices (such as labor market indices) and financial indices. This paper deals with financial indices. So why are financial indices so important? It all comes down to the central role they play in the global capital markets: Performance Benchmark: Financial Indices serve as a performance benchmark for market participants such as active fund managers. Broad-based stock market indices track the performance of a stock market. This provides a critical insight into investor sentiment regarding the state of the economy. Market Behavior: Financial Indices provide information on market behavior. They serve as a proxy for the aggregate price changes of all assets in a stock market. This provides market participants with information on the direction or volatility of a market or segment. Passive Fund Management: Financial Indices play an important role in the passive fund management industry. There has been an increasing trend in recent times to create passively managed mutual funds. These are based on market indices and are known as index funds. Index funds intend to replicate the composition of an index and reduce the detailed research entailed in active fund management. Indices also serve as an underlying factor for creating a related type of investment - Exchange-Traded Funds (ETFs). Who provides financial indices? Increased demand for complex financial indices has been met by a growth in the number of index providers. S&P indices (such as S&P 500) and Dow Jones indices (such as Dow Jones Industrial Average) feature among the prominent index providers. Other important providers include Morgan Stanley Capital International (MSCI), Russell and Wilshire indices. Additionally, many fund houses construct their own indices. This has resulted in a wide range of customized indices in the market. For example, SG Index - a new provider of indices constructs the SGI Wise Index that provides exposure to European Equities. 3

4 2 Index Methodologies How are indices calculated? Indices can be calculated using a number of different methodologies. This paper considers two methods that are most commonly used Market Capitalization Weighted Indices and Equal Weighted Indices. Capitalization Weighted Indices: According to this methodology the stock price is weighted in proportion to the market capitalization of the company. This implies that a small shift in the price of a large company can have considerable impact on the index value. In fact, the majority of stock indices are capitalization weighted indices. This includes the S&P 500, MSCI s indices, FTSE s indices and Russell s indices. Illustrative Example: The S&P 500 is calculated as: Index Level = Index Market Value / Divisor Index Market Value = Pi Qi Where P i & Qi denote the price and quantity of stocks i, respectively. The divisor is a scale factor and can be used to control for events such as capital actions or additions / deletions of stocks to an index and also various corporate actions such as stock splits, spin-offs and rights offerings. These events will result in a change in the market value of stocks which should not be reflected in the index level. This is achieved by making adjustments to the divisor. Two variations of Capitalization Weighted indices exist - Full Weighting and Float- Adjusted Weighting: Full Weighting: In the full weighting method, the value of all outstanding shares is taken into account in the index calculation. Float- Adjusted Weighting: In the float-adjusted method, only the value of the shares that are available to investors is factored into the calculation. Standard and Poor s capitalization weighted indices use the float-adjusted weighting method. Illustrative Example: S&P calculates an Investable Weight Factor (IWF) which represents the percentage of total shares outstanding: Q = IWF * Total Shares i i i Index market value = Pi * Sharesi * IWFi i i 4

5 Equal Weighted Indices: According to this methodology, each constituent stock has the same (equal) weight in the index. However, as stock market prices fluctuate the weights will change. For this reason, equally weighted indices are required to be rebalanced on a periodic basis to ensure each constituent stock in the index has an equal weight. This contrasts to capitalization weighted indices whereby in the absence of any capital actions or corporate actions no rebalancing is required. Illustrative Example: To achieve equal weights at each re-balancing, S&P calculates the adjusted stock market value: Adjusted Stock Market Value = P * Shares * IWF * ER * AWF i i i i i i AWFit, = Z / N * Float Adjusted Market Value Where N denotes the number of stocks in an index, AWF denotes the Adjustable Weight Factor and Z is an index specific constant required for deriving the AWF. Other Methodologies: A number of alternative methodologies exist for calculating indices. This includes indices that are weighted by other factors such as maximum weight restrictions or alternatively another group of indices commonly referred to as leverage and inverse indices. 5

6 3 Index Creation Process Prior to the Index Life Cycle Business User: The business user establishes the requirement for a new index and formulates a method for its construction. The model is captured in the form of an Excel spreadsheet which is passed along to the IT team. The IT team may be a project team within a third-party vendor. Specification Document: To elaborate on the model a specification document is provided by the business user to the project team. This document contains the business user s requirements for the construction of the index. This details requirements on Data Capture, Returns and Analytics, Index Calculation, Index Rebalancing, Sanity Checks and Publishing Channels. Index Life Cycle The process of creating and maintaining an index is a continuous one. Figure 1 illustrates the daily life cycle of a typical index. Day Start Data Capture Check Calculate Analytics / Returns Check Create Membership List Check Calculate Index Analytics and Returns Check Business User Sign-Off and Publication Day End Figure 1: Index Life Cycle 6

7 Data Capture: The daily calculation process commences with various external (e.g. Reuters, Bloomberg) and internal data sources feeding asset prices automatically into a central database. However, it may be possible that some data is incomplete or alternatively some customized data is required. This would be provided by the business user. In this scenario, the required data would be uploaded manually from an Excel spreadsheet by the project team. This is achieved using POI, API, JXLS, SQL Loader, and Direct Data Manipulation using tools such as Toad and SQL Navigator. Analytics/Returns: Various analytics and returns are calculated. Analytics include Accrued Interest, Yield, Duration, and Convexity. Return calculations include Price Returns, Coupon Returns, Local and Multiple Currency Returns, Hedged and Unhedged Returns. Membership List: Once the analytics and returns are calculated, a selection criterion (often referred to as business rules) is applied to determine the members of a particular index. These selection criteria can be either rule-based or style based. Illustrative Example: Business Rules For example, for equity indices Russell Investments applies the following criteria to determine the members of its US equity indices. Rule Based Rank U.S. common stocks from largest to smallest market capitalization at each annual reconstitution period Top 3,000 stocks become the Russell 3000 Index Largest 1,000 stocks become the Russell 1000 Index Next 2,000 stocks become the Russell 2000 Index Style Based Rank each stock in Russell 1000 and Russell 2000 by two variables: the book-toprice ratio and the I/B/E/S forecast long-term growth mean Combine variables to create a Composite Value Score (CVS) for each stock Rank stocks by their CVS and apply a non-linear probability algorithm to the distribution to determine style membership weights. Approximately 70% are classified as all value or all growth and 30% are weighted proportionately to both value & growth. 7

8 Index Analytics and Returns: The underlying securities are aggregated to generate an index: Examples of Index Analytics Aggregated on beginning market value of underlying instruments Aggregated on current market value of underlying instruments Based on Components Performance for an Composite Index Examples of Returns Analytics Clean Price Level Index Level Excess Return Calculation Gross Total Return Sanity Checks: The data undergoes extensive pre- and post-sanity checks: Examples of Pre-index Calculation Checks: Check for Missing Prices, Check for Large Price Changes, Check whether T-Bill Yield has been captured Examples of Post-index / Pre-weight Checks: Check for Missing Zero or Null Daily Coupon, Check if Index Return is Missing, Check for Index Level Jump Business User Sign-off and Publication: The project team is required to obtain the sign-off from the business user. The indices are published via a number of channels. This includes the Web, FTP Reports and Reports to internal and external users, and also publications to external data providers such as Bloomberg and Reuters. 8

9 4 Index Maintenance Periodic Rebalancing: Once the index is created it is required to be rebalanced (changing the weights of constituents) on a periodic basis to ensure that the index reflects underlying market developments. The business user will typically have its own proprietary model to calculate the revised weights required for rebalancing. These models are confidential to the business user and so only the resultant weights are supplied to the project team. It is then the project team s responsibility to implement the rebalancing with the aid of the specification document. Illustrative Example: Specification Document For rebalancing purposes, the specification document will detail information such as: Rebalancing Frequency: Rebalancing Frequency (monthly/quarterly) is stated for both the Master Index & Component Indices (in the case of a Composite Index). Rebalancing Cost: Each time a component index is rebalanced, a cost (expressed in basis points) may be incurred. In this scenario, the model used to compute the rebalancing cost will be disclosed. Performance Threshold: This threshold is required to be exceeded to trigger the need for rebalancing. Roll Period: This applies to commodity indices. It is the period within which (progressive) rebalancing is required to be achieved. For example, this may be specified as 3 London business days. Special Rebalancing: In addition to periodic rebalancing the business user may require special rebalancing. The demand for special rebalancing arises out of the need to control volatility in financial markets. One example of a special rebalancing mechanism is called an Overall Volatility Trigger. If the magnitude of the volatility exceeds a pre-defined threshold X times, then the rebalancing mechanism is automatically triggered. Corporate Actions: Corporate actions (e.g., stock splits, spin-offs, rights offerings, share issuance, share repurchase and special dividend payments) result in changed values for the stock price, number of outstanding stocks and stock market capitalization. For equity indices, the objective of index maintenance is to ensure that the index level is unaffected as a result of corporate actions. This is achieved through making adjustments to the divisor in the index calculation. 9

10 5 Key Challenges in ICE Design In the following section we discuss some commonly cited challenges faced when designing an Index Creation Engine (ICE): Flexibility for Modernization: The demand for customized indices necessitates the need for a modular and flexible approach towards designing an ICE. For example, the design should have the capability to accommodate for the addition of new indices, variants of existing indices and for the modification of index calculation methodologies. Processing Power for Speed: Time is of the essence in financial markets, and players are increasingly demanding improved real-time indices. This dictates the need for improved processing power which requires continuous innovation in ICE design. Cross-Currency/ Time Zones Increases Complexity: The globalization of the financial markets has increased the complexity involved in constructing indices. For example, emerging market indices require currency normalization as well as adjustments for varying time zones. Optimizing Index Re-calculation: The optimal frequency of index recalculation is dependent on a number of factors. These factors include the complexity and the amount of data that is required to be processed, the frequency at which the input system receives data as well as the number of data points that needs to be handled. 10

11 6 About HCL Technologies HCL Technologies HCL Technologies is a leading global IT services company, working with clients in the areas that impact and redefine the core of their businesses. Since its inception into the global landscape after its IPO in 1999, HCL focuses on transformational outsourcing, underlined by innovation and value creation, and offers integrated portfolio of services including software-led IT solutions, remote infrastructure management, engineering and R&D services and BPO. HCL leverages its extensive global offshore infrastructure and network of offices in 19 countries to provide holistic, multi-service delivery in key industry verticals including Financial Services, Manufacturing, Aerospace & Defense, Telecom, Retail & CPG, Life Sciences & Healthcare, Media & Entertainment, Travel, Transportation & Logistics, Automotive, Government and Energies & Utilities. HCL takes pride in its philosophy of Employee First which empowers our 52,957 transformers to create a real value for the customers. HCL Technologies, along with its subsidiaries, had consolidated revenues of US$ 2.0 billion (Rs.8974 crores), as on 31st December HCL has a global network of offices in 19 countries: Australia & New Zealand, China, Europe, Hong Kong, India, Japan, Latin America, Malaysia, Middle East, Singapore, US. Financial Services in HCL Technologies The Financial Services is one of the largest growing verticals in HCL. Using a value centric approach to the enterprise, over 8500 'transformers' in HCL have been transforming technology into competitive advantage for some of the largest financial services organizations in the world. The Financial Services practice in HCL is built on strong domain competencies spanning Retail and Corporate Banking, Capital Markets, and Insurance, catering to the IT and operational needs of leading financial services companies. About the Author Michael works in the Business Solutions Group of HCL Capital Market Services. Prior to joining HCL Michael completed a Bachelors degree in Accounting & Finance from Cardiff Business School & a Masters degree in Finance from Warwick Business School. Michael can be contacted via at the following address: Michael.Walker@hcl.in Michael formulated the white paper based on HCL s extensive experience in providing index creation & maintenance services to a leading Fortune 50 Global Investment Bank for a period of over 7 years. 11

NIFTY 50. Index Methodology. August 2017

NIFTY 50. Index Methodology. August 2017 NIFTY 50 Index Methodology August 2017 Contact: Email: iisl@nse.co.in Tel: +91 22 26598386 Address: Exchange Plaza, Bandra Kurla Complex, Bandra (East), Mumbai- 400 051(India) Contents Introduction...