With passive investment on the rise, providers are seeking to make indices out of anything that will fit. Equities are now indexed by sector, sub-sector, region, style and environmental record, and fixed income indices can be tracked successfully by institutional and retail investors alike.
Commodities too, can now be held by pension funds in the form of an investment which tracks an index. But can all markets be indexed? How far can the concept of indexation be taken?
“In principle, the key is to ensure the components or constituents of the index are tradeable – not only physically tradeable but also of a sufficient market size,” says Carl Beckley, director of market development at FTSE International.
This is why equities lend themselves well to indexation, and why investment instruments can successfully replicate the equity indices.
Fixed income instruments such as government bonds can also be indexed with few problems. Government bonds form a highly liquid market. However, there can be difficulties involved in running or following indices based on corporate bonds, says Beckley.
“Corporate bonds tend to be very liquid in their first few months of issue, but after that the market dries up. The bonds tend to get into the hands of long-term investors and then there is no reason for them to trade, so corporate bonds can be quite a problem.
“Similarly, indices tracking smaller stocks can falter. Some small stocks are less liquid and tracking error in investments attempting to follow these tends to increase,” says Beckley.
“There are other forms of investment which do not easily lend themselves to indexation,” says Alvar Chambers, senior investment consultant at Aon Consulting. “For alternative investments, such as private equity and hedge funds, it’s much more difficult because these are illiquid investments.”
“Hedge funds can be problematic for those seeking to run indexed investments in them. This is largely due to the nature of hedge funds, which tend to be closed to new investment after a certain launch period,” says Beckley.
Commodities are tracked by indices – notably the Goldman Sachs Commodity Index (GSCI), the S&P Commodity Index and the Dow Jones-AIG Commodity Index – which can form the bases for investments. Beckley points out that commodity futures contracts tend to be fairly liquid, lending the market well to indexation. But the problem with indexing commodities is in how to weight them within an index.
The biggest commodities market in the world in terms of value is oil, but if this component was given its true weight within a commodities index, it would overshadow all other commodities, says Beckley.
“The majority of pension funds who have invested in commodities have done it through the index market, and the main reason the GSCI was set up was to provide investors with a reliable and publicly available – investable – benchmark for investment performance in the commodity markets comparable to the S&P500 or FT equity indices,” says Heather Shemilt, vice president and head of global GSCI.
“There are a variety of ways investors can gain exposure to commodities through the GSCI,” says Shemilt. “Typically, they can enter into a total return swap which usually runs for one or three years.”
Indexation is ideal for equity investors seeking to use commodities as diversification. A pension fund, for example, looking for exposure to the commodities market would need a basket of commodities to invest in rather than holding individual commodities. “They didn’t have a view on the corn market, per se, for example,” says Shemilt.
The case for commodities as a diversification away from equities has been made clear this year, with the GSCI up 28% year-to-date.
The fact that oil makes up a large percentage of the index – around 66% – is not a problem, says Shemilt, but rather a benefit. “Energy is what’s driving diversification,” she says. “If you gave it a lower weighting, you’d have to buy more of that index to get the same benefit.”
Beckley says there are particular difficulties with the idea of indexing private equity. Here, investments are made in private companies where it is not possible to know the value of that company at any one time. “If you want to run an ETF, you need minute-by-minute prices, and you simply can’t do that with private equity.”
Chambers says the problem with private equity in this context is that valuations are subjective. “If there is no one actively trading, then the book value may be out of date and may not reflect the true value of the investment.”
“The key to any passive investment is the liquidity of the underlying constituents, and the availability of pricing,” says Beckley. Without this, any attempt at indexation is likely to be compromised.