David Koenig serves as Investment Strategist on the Research and Innovation team for Russell Investments’ family of global indexes. In this email interview with SmartBrief, Mr. Koenig discusses the methodology Russell uses to construct its indexes.
Russell has been a leader in indexing since it first developed its U.S. index series about 30 years ago, including the first small cap benchmark, the Russell 2000. How has the industry evolved since then and how are investors using index-based investment strategies today?
We introduced our U.S. index series in 1984 to give investors more precise indexes than existed at that time. This was a time in which investment managers were essentially all measured against one index, and we recognized that investors needed more precise tools to better measure markets and assess investment manager skill. We understood that not all investment managers exhibited the same behavior, with some focusing on larger companies and others on smaller companies. That led us to develop the broad Russell 3000 Index and its size components, the large cap Russell 1000 Index and the small cap Russell 2000 Index. And we followed that in 1987 with the development of the first growth and value style indexes. These innovations have of course become industry standards since that time.
In recent years, the industry has seen the introduction of a number of strategy indexes often referred to as ‘Smart Beta.’ These indexes typically focus on either a single risk factor or a set of factors, and they’re generally not market cap-weighted. Although indexes such as the Russell 2000 are capitalization weighted, we view them as Smart Beta 1.0, since they gave investors access to more precise market segments than had previously existed. We consider the recent evolution to non-cap-weighted indexes as Smart Beta 2.0. And we’ve continued our heritage of innovation with the addition of several new alternatively weighted index series — including equal weighted, fundamentally weighted and low volatility indexes.
Investors have continued to gain increasing interest in these indexes as complements to both actively managed strategies and traditional cap-weighted indexes because they offer a way to diversify index-based exposures and potentially improve risk-adjusted returns relative to the cap-weighted index—either through enhanced returns or lower risk—while retaining the benefits of indexes such as a rules-based methodology, transparency, capacity and liquidity.
With thousands of index-based investment products in the marketplace, what are some of the key criteria investors should consider in selecting an index?
There are many features of index construction that investors should be aware of when selecting an index as either a benchmark or as the basis for an index-based investment product such as an ETF. At Russell, we know that all indexes are not created equally and that methodology matters. Indexes focused on the same market segment can have material differences in design, resulting in meaningful differences in exposure and performance.
As a way to help investors begin to better understand their indexes, we put together a simple framework to highlight the key criteria investment professionals consider when selecting an index as either a benchmark or as the basis for an investment strategy. We start with three broad categories — Market Coverage, Construction Approach and Ongoing Maintenance — and then consider several important criteria within each category. These include:
- Representation: Does the index provide comprehensive and representative coverage of its intended market segment?
- Portfolio Fit: How does its market coverage affect broader portfolio risk/return? And how does it fit with portfolio objectives and tolerance for risk?
- Objectivity & Transparency: Is the index constructed using a rules-based and transparent approach, where the rules are clear and readily available in a published methodology document?
- Weighting: How is the index weighted? By market capitalization, fundamental characteristics or low volatility measures?
- Ongoing Maintenance: Are IPOs, mergers and other corporate actions added or removed using a disciplined, predictable process?
- Rebalancing: How frequently is the index rebalanced? Annually, quarterly, monthly?
These are just a few areas that give investors a basis for truly understanding the indexes they rely on every day. We believe it’s important for investors to understand the methodology of the indexes underlying their investments. Being educated and informed about index methodology can help investors avoid unintended investment decisions and potentially unexpected outcomes.
As the number of choices and the sophistication of index-based investment strategies have grown, the need for investor education has increased as well. What are index providers doing to help educate investors about all of these indexes and how they can be used to measure and manage client portfolios?
The number and sophistication of index-based investment strategies certainly has grown in recent years. At Russell, we believe that innovations that offer a clear benefit to investors and the markets are a good thing. We also recognize that with the thousands of indexes in the marketplace today, it can be confusing. We’ve taken steps to enhance our educational efforts, and are devoting significant resources to the creation of white papers, videos and other materials with content relevant to the issues important to financial advisors and clients. We meet directly with financial advisors to make sure we clearly understand their needs and concerns first-hand, and are available to educate investors on the unique factors, exposures and quality of Russell’s indexes. We recently launched a new website to support these efforts at www.methodologymatters.com.