## Getting Up to Speed with the Essentials of Index Construction

Head of South Asia

S&P Dow Jones Indices

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Why choose index investing? Yes, the merits of diversification and low cost are usually factored in, though one critical benefit that many do not realize is the transparency that is provided in the methodology of an independent index provider. To understand what goes into the design and methodology of an index, it’s important to note that it’s not a random pick of securities to represent the index’s concept or design. So, let’s skim through some basics of index construction.

Indices offer a wide range of options whereby their calculation methods might vary. Most equity indices are market-cap weighted and float adjusted, where each stock’s weight in the index is proportional to its float-adjusted market value. Some equity indices are price-weighted indices, in which constituent weights are determined solely by the prices of the constituent stocks in the index. An example would be the Dow Jones Industrial Average®. Then there are equal-weighted indices in which each stock is weighted equally in the index. There can be restrictions placed in the index where certain constituents are assigned a minimum or maximum weight, and this can be applied to sectors as well. A few more to add to the variety are options include leveraged and inverse indices, which return positive or negative multiples of their respective underlying indices, dividend indices, which track the total dividend payments of index constituents, and the list goes on.

A common query among many is how exactly is an index calculated? Is it a simple average, or is there some complex formula that runs that magic number? The key concept to understand index calculation would be the index divisor. In a capitalization-weighted index, wherein the portfolio consists of all available shares of the stocks in the index, the total value will be a large number (e.g., the float-adjusted market value for the S&P 500® is a figure in the trillions of U.S. dollars). Hence, to make it easy, the number is scaled down by dividing the portfolio market value by a factor, usually called the divisor.

An index does not behave like a portfolio, as a stock that is added to or deleted from an index would not result in the index level changing, in contrast to a portfolio’s value that would usually change to reflect movements in its holdings. To ensure that the index’s value, or level, does not change when stocks are added or deleted, the divisor is adjusted to offset the change in the market value of the index. Thus, the divisor plays a critical role in the index’s ability to provide a continuous measure of market valuation when faced with changes to the stocks included in the index. In a similar manner, some corporate actions that cause changes in the market value of the stocks in an index should not be reflected in the index level. Adjustments are made to the divisor to eliminate the impact of these corporate actions. There is a large range of different corporate actions, from routine share issuances or buybacks to less-frequent events such as spin-offs or mergers. The index provider details the impact of such corporate actions in their methodology document. The application of changes depends on the type of index and the need for the adjustment with respect to the announced corporate action.

Furthermore, index providers list the rebalancing schedule of the index so that the index is consistent with the methodology.

Index providers do not create the passive products, and hence there is complete independence and a lack of bias to the passive product offered by a product provider. For the product provider as well, they can impress upon the neutrality of the product, as the underlying design is based upon the index provider’s methodology.

Exhibits 1 and 2 provide a sample of different index types and their trends.

The posts on this blog are opinions, not advice. Please read our Disclaimers.

## Dive Deeper into the S&P/BMV Total Mexico ESG Index

Director, Client Coverage, Latin America

S&P Dow Jones Indices

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S&P Dow Jones Indices (S&P DJI) and BMV recently launched the long-awaited S&P/BMV Total Mexico ESG Index to great fanfare. The Mexican equities market is in the early stages of exploring ESG-related concepts, from sustainable assessments at the issuers’ level to sustainable investments for asset owners, asset managers, and regulators. The S&P/BMV Total Mexico ESG Index, which uses the world-renowned Corporate Sustainability Assessment (CSA) from SAM (part of S&P Global), is a local index that employs the latest international standards and best practices.

The following statistics aim to highlight the main characteristics of the S&P/BMV Total Mexico ESG Index:

• The index currently includes 29 constituents, but this amount can change during its annual rebalancing. Of these constituents, 23 are also in the S&P/BMV IPC. One of the main differences with the S&P/BMV IPC is that the S&P/BMV Total Mexico ESG Index includes FIBRAS (REITs) in order to recognize these companies from an ESG perspective;
• As of July 20, 2020, the S&P/BMV Total Mexico ESG Index represented 68% of the market cap of the S&P/BMV IPC;
• The weight of the largest constituent was 6.9% as of July 20, 2020, while the largest company in the S&P/BMV IPC was nearly 16% of the index;
• The S&P/BMV Total Mexico ESG Index has an ESG profile that is 17 points higher than its benchmark index, the S&P/BMV Total Mexico Index. This represents a maximum potential increase in its ESG profile of 43% over the benchmark;
• Looking at sector diversification, we find that nine GICS® sectors are represented in the index (see Exhibit 1).

How many of the constituents in the S&P/BMV Total Mexico ESG Index are included in the other S&P ESG Indices? Let’s see: 15 constituents of the S&P/BMV Total Mexico ESG Index are also constituents of the Dow Jones Sustainability MILA Pacific Alliance Index (55 constituents)—this is noteworthy considering that the methodology of each index is different per the following:

• The Dow Jones Sustainability MILA Pacific Alliance Index is a best-in-class methodology in which the top 30% per industry are selected; while
• The S&P/BMV Total Mexico ESG Index seeks to be aligned with the principal sustainability criteria. The index applies exclusions based on certain business activities and non-compliance with the UN Global Compact criteria. It is weighted by S&P DJI ESG score.

In addition, three companies in the S&P/BMV Total Mexico ESG Index are also members of the Dow Jones Sustainability Emerging Markets Index, which has 97 constituents in total.

Finally, it is important to mention that of the 29 index constituents, 26 completed the SAM CSA, while for the remaining three constituents, SAM performed the evaluation using their public information.

Considering these points, we see the S&P /BMV Total Mexico ESG Index complies with the characteristics of liquidity, representation, replicability, and diversification, which could allow it to be used as benchmark or in financial products such as ETNs.

###### I would like to acknowledge Silvia Kitchener for her contribution to this blog.

The posts on this blog are opinions, not advice. Please read our Disclaimers.

## Dollar Malaise Supports Commodities in July

Head of Commodities and Real Assets

S&P Dow Jones Indices

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The S&P GSCI rose 3.8% in July 2020, taking its YTD performance to down 33.9%. Weakness in the U.S. dollar against a range of currencies supported commodities. The broad U.S. dollar fell to a two-year low at the end of the month. Lower real rates, a weaker dollar, and widespread fiscal and monetary stimulus measures continued to boost demand for precious metals, which are considered a hedge against inflation and currency debasement.

Following the volatility of the first six months of 2020, July proved rather subdued for the global energy complex. The S&P GSCI Energy up was 2.6%, buoyed by a weaker U.S. dollar. But the ongoing recovery in oil demand remains tempered by continual concerns over the recovery of the global economy, in light of a second wave of COVID-19 in many parts of the world. From a supply perspective, bloated U.S. crude oil inventories have finally started to fall, while OPEC’s decision to ease production curbs offers them some flexibility should demand weaken further.

Continued positive economic data out of Asia boosted the S&P GSCI Iron Ore by 14.4% and the S&P GSCI Industrial Metals by 6.7% in July. The positive demand for iron ore out of China continued as the country increased spending on infrastructure to fight the economic shock from the pandemic. The S&P GSCI Zinc fully recovered from the drop in H1 2020 and outperformed the other industrial metals that make up the S&P GSCI Industrial Metals over the month, ending up an impressive 13.2%.

The less-precious metal, the S&P GSCI Silver, jumped higher in July, up 30.0%, after flat performance in the first half of the year. A pickup in industrial uses of silver and a new all-time high for spot gold helped the precious metal post a month-to-date performance almost double the next closest S&P GSCI constituent. The S&P GSCI Gold continued its march higher in July, rising 8.6% over the month. The ongoing rally in gold is likely a sign that investors are suffering a new bout of nerves over the outlook for the global economy and a second wave of COVID-19 cases.

The S&P GSCI Softs rose 7.5% in July, continuing to chip away at the negative YTD underperformance. Most of the heavy lifting was done by the S&P GSCI Coffee. The hardest hit of the softs so far in 2020, S&P GSCI Coffee gained 17.8% in July on the back of concerns that the pandemic was spreading in the coffee growing regions of Vietnam. With hotspots in South America still raging, concerns are mounting that coffee supplies may be affected.

The S&P GSCI Livestock recovered some ground in July, ending the month up 6.1%. The S&P GSCI Live Cattle rallied 7.2% on the back of a long-awaited uptick in weekly beef export sales and improved U.S. summer grilling demand.

The posts on this blog are opinions, not advice. Please read our Disclaimers.

## A Dynamic, Diverse, Multi-Asset Approach to ESG

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The S&P ESG Global Macro Index is designed to capture potential opportunities across market conditions through a rules-based, geographically diverse, dynamic mix of ESG equities and fixed income.

The posts on this blog are opinions, not advice. Please read our Disclaimers.

## Observing a Regime Change

Senior Director, Index Investment Strategy

S&P Dow Jones Indices

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In politics, “regime change” denotes the replacement of one governmental structure with another; in economics, we use the same term to indicate a shift in the interactions of various parts of the economic or financial system. Political regime changes are easy to identify (after all, a military coup is hard to miss).  Defining when an economic regime change has occurred can be more difficult.  One way to do it is to observe the interaction of sector and factor indices.

In the first six months of 2020, there were major changes in sectoral volatility.  Exhibit 1, which shows factor tilts relative to the S&P Composite 1500® benchmark, demonstrates the changes in the Real Estate and Utilities sectors, both of which are traditionally defensive. Both of these sectors decreased their exposure to the low volatility factor (from well above average to neutral), and simultaneously experienced an increase in their tilt towards high beta (from well below average to neutral).

Source: S&P Dow Jones Indices LLC and FactSet. Data as of January and June 2020. Chart is provided for illustrative purposes.

In contrast, Exhibit 2 illustrates that traditionally riskier sectors like Health Care and Technology moved in the opposite direction – increasing their tilt towards low volatility, decreasing their tilt towards high beta, or both.

Source: S&P Dow Jones Indices LLC and FactSet. Data as of January and June 2020. Chart is provided for illustrative purposes.

What these exhibits demonstrate is that we have witnessed a major shift in the location of both low volatility and market sensitivity.  “Risk off” sectors from a year ago have become riskier; last year’s “risk on” sectors have become, if not defensive, at least much less aggressive.

Sector indices are, in one sense, an ideal vantage point from which to observe market regimes because their turnover is very low. A utility remains a utility, and a technology company a technology company, regardless of the market’s cycles; when we observe changes in a sector index, as in Exhibits 1 and 2, we’re observing changes in a largely constant set of stocks.  These exhibits, in other words, tell us that relatively static sets of stocks experienced large changes in factor exposures.  We might therefore expect that the relevant factor indices would witness very large changes in sector exposures.

As indeed they did. As a result of the May rebalance, the S&P 500 Low Volatility Index decreased its weight in Real Estate and Utilities and increased its weight towards Consumer Staples and Health Care. The S&P 500 High Beta Index reduced its weight in Information Technology and increased its weight towards Financials. These sector shifts led to record turnover for these indices of 65% and 56%, respectively.

The size of these shifts isn’t surprising. Factor indices, after all, embody their factors “perfectly” only when they’re rebalanced; after that, the factor index and the factor itself can drift apart.  Other things equal, drift will be higher when the market’s dispersion is high, as it was earlier this year; the higher the drift, the larger the subsequent rebalance must be.

Sectors and factors are different ways of viewing the world, but they are not mutually exclusive. Seeing both perspectives helps us to understand market regime changes as they occur.

The posts on this blog are opinions, not advice. Please read our Disclaimers.