2013 volume 6 issue 4

A Guide to Indices

Membership in the S&P/TSX Composite Index or an international equivalent has long been coveted by public companies. With the rise of Exchange Traded Funds (“ETFs”), investing to mirror index performance, index inclusion is more valuable than ever.

It is little wonder that IROs often hear retail investors ask whether their companies have considered applying for inclusion in  a particular index. Alas, it is not that simple.

In order to capture institutional clients who buy licenses to use index families as the basis for their investment products, asset allocations, portfolio hedging and performance benchmarks, index providers must ensure that any index bearing their corporate seal is an accurate measure of the market it represents. Therefore there is no way for a public company to apply for index membership – you are either in or out based on a series of calculations made by the index provider acting on publicly available information.

Surprisingly then, given the importance attached to index membership, the methodologies used by indices vary greatly. It was only in July 2013 that the Index Industry Association (“IIA”) (www.indexindustry.org) published a ‘best practices’ guideline for index providers. This set of 10 practices covers index governance, quality and transparency of index methodologies, timely publication, conflicts of interest, etc. It is one of the ways IIA members, who have collectively calculated indices since 1896, distinguish themselves from other reference-rate benchmarks that may be subject to abuse, conflicts of interest or manipulation.

Recall the uproar a year ago about Libor (London Interbank Offered Rate), the benchmark for interest rates, to see why IIA members – who in aggregate calculate over one million indices worldwide – wish to differentiate themselves.

Canada’s most widely followed benchmark, the S&P/TSX Composite is maintained by a seven-person committee responsible for administering the methodology for inclusion and ‘rebalancing’ the index, which results in security additions and deletions in March, June, September and December of each year. Once removed, a security is not eligible for re-inclusion for 12 calendar months. Since information about changes to its Canadian indices is considered potentially market-moving, the index committee’s deliberations are confidential, but its policies are available at www.spindices.com.

Other major providers of index data that are also IIA members include the FTSE Group (FTSE), which is owned by the London Stock Exchange, Barclays, Markit, MSCI Inc., NASDAQ OMX, and Russell Investments.

Index Classifications

Indices are built for different purposes but generally can be segmented by category:

  • Market capitalization indices require companies to meet minimum and/or maximum market value thresholds;
  • Equally weighted indices seek to eliminate bias to one large company (remember Nortel) by giving equal exposure to each security, regardless of size; and
  • Factor weight indices are confined to securities that all share a characteristic, such as P/E or price-to-book values, common or preferred share payments.

Horizons S&P/TSX 60 Index ETF and iShares S&P/TSX 60 Index Fund are examples of market cap index-linked ETFs. Claymore S&P/TSX Canadian Dividend ETF is a factor weight ETF, while BMO S&P/TSX Equal Weight Banks Index ETF is an equal weight index fund.

There is no doubt that index inclusion comes with bragging rights – not to mention at least an initial uplift in share price (or a downdraft for companies dropped). On the flip side, an index serves as an inescapable performance benchmark. Just ask an IRO who is called to account for a total return that has fallen below the S&P/TSX Composite Index. While there is no way to avoid benchmark comparisons, it is important to understand how key indices are constructed – and what indices are most relevant to your company.

Key Indices

So what are the key indices? The answer depends on what country, what industry and what size of company is asking the question.

For example, many emerging Canadian companies covet inclusion in the S&P/TSX SmallCap Index. Current headline measures for inclusion in this index include:

  • Market capitalization of greater than or equal to $100 million and less than or equal to $1.5 billion on both a quoted (float adjusted) basis and a total market basis, using the volume-weighted average price over the last three trading days of the month-end prior to annual review;
  • A float turnover (total shares traded at a Canadian venue in the last 12 months divided by the float adjusted shares outstanding at the end of the period) of 0.50; and
  • Canadian domiciled and listed on the TSX.

The rite of passage for larger Canadian companies is inclusion in the S&P/TSX 60 Index (market cap over $5 billion). Similarly, the S&P 500 is considered the promised land for U.S. domiciled equities (American Depository Receipts are not eligible and foreign issues have been excluded for over a decade), with minimum market capitalizations of US$3.5 billion and that have been ‘seasoned’ for six to 12 months. This latter criterion means Facebook, for example, with a market capitalization of some $90 billion, is not yet in the S&P 500.

Sector Indices

While some indices are considered universal benchmarks, it is just as important to be included in an industry sector index. To standardize industry descriptions, MSCI Inc. and Standard & Poor’s developed the Global Industry Classification Standard (GICS). It provides definitions for 10 sectors, including financials, information technology, consumer staples, consumer discretionary, industrials, materials, energy, health care, telecommunications and utilities. These classifications, available at www.msci.com/resources/pdfs/GICSSectorDefinitions.pdf, are quite broad. For instance, an industrials index may include aerospace and defense contractors alongside building products companies, and a materials index may include a mining company and a forest products company. Accordingly, index providers create sub-indices for greater comparability.

In mining, an often-quoted benchmark is the Materials Index, which is comprised of diversified metals and mining companies, as well as gold and precious metals companies and several other enterprises. But investors and IROs may find a better, more comparable benchmark in, say, the S&P/TSX Global Mining Index, the S&P/TSX Global Base Metals Index or the S&P/TSX Global Gold Index.

For energy companies, a key benchmark is the S&P/TSX Energy Index, which again includes companies in different but related categories such as oil and gas exploration and integrated oil and gas.

Overall, index providers are constantly innovating, which means sub-indices continue to launch and, with them, more ETFs.

Tips for IROs

While lobbying for inclusion in a credible index is pointless, there are some things IROs should consider:

  1. If you feel your company is in the wrong index, or is being improperly excluded, ask to see the index provider’s methodology document and state your case. At a minimum, an index manager should be made aware of your feedback. This may not alter the situation, but it will give you a better idea of deficiencies that are holding you back. Knowing index inclusion methodologies will also allow you to do your own predictive modelling, so you can spot, in advance, potential for your company to be added or subtracted from a key index during rebalancing season. 
  2. If your company does not yet qualify for inclusion, consider how you might help the process along. For example, can you create a more active market in your company’s stock so that liquidity improves to threshold levels? Can you help your company make an acquisition that will increase corporate value, or ensure your company is better aligned with an index in which you wish to be included?
  3. If your company has been ‘rebalanced’ out of an index, make sure you know why so that you can address the reasons when investors ask – because they will.
  4. Currently, providers calculate more than one million indices – so your company might be  part of an index and not even know it. While there is no way to do a universal Internet search of index constituents, you can contact the client services team of an index provider and inquire.
  5. If your company is a member of a small cap index, flaunt it, by including this information in your boilerplate paragraph.   
  6. Remember that not all ETFs are passive; some are actively managed to outperform rather than track a particular index. Traditional IR outreach may not be in order but you should, at a minimum, understand the investment drivers of ETFs in your stock, which again points to the value of knowing index inclusion methodologies.

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