When cooking a meal, great importance is placed on the right ingredients. It’s not much different with index construction. Here too, the right stocks make the difference. At Quantifeed, we are transparent about our index design. In this article, we discuss some of our recipes.
Currently, some of the investment strategies most in-demand have a thematic approach at their core. Thematic indices offer exposure to a certain economic, social or technology trend. Examples are the rising use of social media or the increasing pressure on global potable water supplies.
Our index design process starts with research. What defines the theme and what are its economic drivers are some of the questions we ask. Next, we aim to identify stocks that are impacted by the factors central to the theme and to decide how to weigh these stocks.
Take the example of the water theme: the strategy comprises companies that are likely to gain in business and value in an environment of increasing water scarcity. The increasing shortage of potable water is a development which plays out over decades. The companies involved in helping to alleviate water scarcity are dispersed over many sectors. To identify relevant companies, we look at the general company profile, as well as specific business revenue segments. Companies active in areas such as water supply networks, water treatment and purification, flow control, measurement and diagnostics technology are considered for the strategy. We also devise a mechanism to exclude companies which should not be in the index. For example, some energy and electrical utility companies do report revenue from water- linked activities, but their share price is driven by factors outside the theme.
Importantly, the process described above is governed entirely by rules and doesn’t require any judgement. We are confident that it systematically selects a relevant group of stocks. Our methodology selects companies that derive more than 90% of their revenue from at least one business segment relevant to the water theme. The index is diversified across sectors, from utilities to industrial companies and health technology.
Our index design integrates with the digital capabilities of our online platform. Because users trade the individual securities comprising an index, an important aspect of design is the tradability of stocks. The number of index components and their weights are other important variables. To improve diversification, we equally weigh our indices or user factors such as volatility or dividend yield. Interestingly, the application of such weighting methods often leads to outperformance and improved risk/return characteristics relative to a traditional market-cap weighted index.
As a further point of differentiation, our online platform allows users the flexibility to adapt the index to their own requirements, for example to facilitate a very low investment amount across a reduced number of stocks. Our platform can generate these changes automatically, or enable the user to modify the index composition by eliminating or adjusting the trading order before submission for execution.
Our strategies are based on themes and factors, such as income or growth, or even dynamic models. Sometimes, we mix things up and combine different approaches to achieve a whole new strategy profile. But that’s the topic of another newsletter.