subject: Etfs How Indices Work And Pay [print this page] Sharemarket indices are the lifeblood of the global exchange traded funds (ETFs) market, because ETFs are 'index investments' designed to replicate the price and yield performance of an underlying index. For example, the iShares MSCI BRIC (ASX:IBK) aims for investment results that correspond to the MSCI BRIC Index. The iShares S&P 500 (ASX:IVV) is based on the S&P 500 Index in the US one of the world's most watched and traded sharemarket indices.
Companies such as MSCI Barra and Standard & Poor's construct and manage hundreds of indices over global, regional and country markets, sectors and industries, and specific investment themes. There are indices for other asset classes. The global ETF boom has seen some index providers create narrower indices, over which ETF providers launch more specialised ETFs.
Think of an equity index as a market-weighted portfolio of companies. For example, the iShares Global 100 (ASX:IOO) aims to match closely the Standard & Poor's Global 100 Index, which is a subset of the S&P Global 1200 Index. The S&P Global 100 Index measures the performance of the 100 largest transnational companies with a minimum adjusted market capitalisation of US$5 billion. Exxon Mobil Corp and Microscoft Corp have the largest weightings in the index.
Most index providers rebalance indices quarterly and have rules for company inclusion. The S&P 500 Index requires market capitalisation above US$3.5 billion and four consecutive quarters of positive earnings. Index rebalancing often sees poorly performing companies replaced by better performers each quarter, therefore investors in the iShares S&P 500 know that the market Index is adjusted to reflect changes in (capitalisation resulting from mergers, acquisitions, stock rights, substitutions and other capital events). The investor pays no transaction cost because this process of change is covered by the ETFs annual management fee*.
The main benefits
Indices have two main benefits. First, they monitor the performance of many companies with a single value the S&P 500 Index's value is a good indication of how US stocks are performing. Smart investors use indices to compare one index with another and benchmark their portfolio's performance against an index they understand it is hard to constantly outperform a related benchmark over time, after fees one reason low-cost index investing is popular.
Second, indices enable investors to trade a view through ETFs. An investor who believes the Japanese sharemarket will recover and is happy with the market return, can buy the iShares MSCI Japan Index, which captures 85 per cent of the market's total capitalisation.
Always look at how an index is calculated. With the iShares MSCI Taiwan (ASX:ITW), for example, information technology stocks account for just over 60 per cent of the underlying index. Investors with a positive view on technology spending may consider this a way to gain exposure to stronger global demand for semi-conductors.
Look at the 'tracking error' (a positive or negative difference between the ETF and the underlying index). Persistently large errors are a worry. You pay for an ETF to consistently provide investment returns that correspond to the index.
Most of all, consider the indices' liquidity. iShares ETFs are based on many of the worlds most-traded indices. Several newer ETF issuers' products are based on indices developed just for that ETF, or have limited history. Low liquidity can mean wider buy/sell spreads, higher tracking errors, and higher costs.
