Index providers generally take a top-down approach to constructing a portfolio by defining:
- the target market;
- the portfolio constituents within that market;
- the weights of individual securities;
- the rebalancing frequency; and
- when to re-examine the portfolio construction methods.
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).
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 as well as the rebalancing methods commonly used in the next learning objectives.
Which of the following is NOT usually a part of the standard index construction process?
A. Deciding how to weight constituent securities within the index
B. Deciding when the index portfolio should be rebalanced
C. Determining an appropriate benchmark for the index
The correct answer is C.
Most of the time, an index can serve as a benchmark but does need to establish a benchmark for its own performance.
Reading 45 LOS 45c:
Describe the choices and issues in index construction and management