Issues in Index Construction

Index providers generally take a top-down approach to constructing a portfolio by defining:

1. the target market;
2. the portfolio constituents within that market;
3. the weights of individual securities;
4. the rebalancing frequency; and
5. when to re-examine the portfolio construction methods.

Target Market

Depending on the index, the target market may be defined broadly or narrowly based on asset class, geographic region, exchange, and/or other characteristics (sector, size, style, duration, credit quality).

Security Selection

Constituent securities are then selected from the available universe of securities in the given target market. Some indices may limit the number of securities to a certain amount, while others may have their number of holdings vary over time. Finally, the securities are weighted based on price, equal weights, market capitalization, or fundamentals (book value, cash flow, revenues, earnings, dividends, the number of employees).

We will see those different weighting methods and the rebalancing methods commonly used in the next learning objectives.

Question

Which of the following is least likely a part of the standard index construction process?

1. Determining an appropriate benchmark for the index.
2. Deciding when the index portfolio should be rebalanced.
3. Deciding how to weight constituent securities within the index.

Solution

The correct answer is A.

In the index construction process, the focus is typically on selecting constituent securities, determining their weightings, and deciding on rebalancing schedules. However, determining a benchmark is not part of constructing the index itself; rather, benchmarks are often used to evaluate the performance of an index or investment portfolio after construction.

Key parts of the index construction process include:

• Selecting securities.
• Deciding how to weight those securities (C).
• Setting rules for rebalancing the index over time (B).